What Types of Annuities are There?

Highlights:

• An annuity is an investment option that is backed by an insurance company and provides a series of future payments in exchange for present-day deposits.
• Annuities can be highly customizable, with variations in interest rates, premiums, taxes and payouts.
• When choosing an annuity, consider your unique needs, such as how long you have before retirement, how quickly you'll need to access your money and how much tolerance you have for risk.

Annuities can provide a source of reliable income during retirement. There are many different types of annuities to choose from, each with unique features, risks and rewards.

Considering an annuity? Here's some things to consider about the different types of annuities, so you can try to choose the best option for you.

What are annuities and how do they work?

An annuity is an investment option that is backed by an insurance company and provides a series of future payments in exchange for present-day deposits.

When you sign an annuity contract, you'll contribute money, either in a large lump sum or as smaller monthly payments, called premiums. Your contributions are made during a period called the accumulation phase. Once invested, your money grows on a tax-deferred basis. All annuities are tax-deferred, meaning your interest earns interest until you make a withdrawal. When it comes time to withdraw your funds, you may owe taxes on either the full withdrawal amount or any interest accrued, depending on the type of annuity you have.

When the accumulation phase ends, you enter the distribution phase. During this time, the insurance company holding the annuity distributes regular payments to you.

Annuities are offered by insurance companies, banks and other financial institutions. Investors usually purchase and pay into an annuity to supply extra cash during retirement.

What are the different types of annuities?

Annuities can be highly customizable, with variations in interest rates, premiums, taxes and payouts. Common types of annuities include:

1. Fixed annuities

A fixed annuity offers a guaranteed minimum payout and interest rate. Fixed annuities are not connected to the fluctuations of the stock market. Instead, they grow at a fixed interest rate determined by the insurance company. As a result, fixed annuities are considered one of the most reliable annuity options. With a fixed annuity, you might receive your payments for a set period of years or as a lump sum, depending on your contract.

2. Variable annuities

Variable annuities feature an interest rate that changes in response to market fluctuations. With a variable annuity, you'll choose where your contributions are invested — you'll typically have low-, moderate- and high-risk options. In turn, your payouts increase or decrease in relation to the performance of your chosen portfolio. You'll receive smaller payouts if your investment performs poorly and larger payouts if it performs well.

3. Indexed annuities

Indexed annuities aim to split the difference between fixed and variable options. With these annuities, your contributions are linked to the returns of one or more market indexes. Many indexed annuities also come with a guaranteed minimum payout, similar to a fixed annuity. However, in exchange for this additional protection, indexed annuities have a cap on how much your investment can earn, even if your chosen index performs well.

4. Immediate annuities

Immediate annuities allow you to begin receiving payouts no later than one year after you contribute your premium. This type of annuity is almost exclusively single-premium, meaning it's funded by a large, one-time contribution.

5. Deferred annuities

If you have a deferred annuity, you'll wait for a certain amount of time before you begin receiving your income stream. This is known as the accumulation period, during which your money grows and you do not pay taxes on your funds yet. Depending on your contract, you can contribute to the annuity with a single premium or with a series of payments.

Which annuity is right for you? Pros & cons of different annuities

Should you pay over time or all at once? Will you take a risk with a variable rate of growth or play it safe with a fixed rate? Can you plan your retirement around your payouts?

To decide which annuity works for your unique situation, you'll need to think carefully about your financial goals. Consider how long you have before retirement, how quickly you'll need to access your money and how much tolerance you have for risk.

Here are some pros and cons of different annuities:

• Fixed vs. variable annuities. The primary benefit of a fixed annuity is its predictable stream of future income. That's why fixed-rate annuities are often the go-to for those planning for retirement.
  
  On the other hand, a variable annuity is less predictable, so you won't receive a guaranteed minimum payout — and if you choose a high-risk investment, you might even lose money. However, a variable annuity can also be more profitable if your investment performs well.
  
  If your goal is to maximize your benefits without taking a loss, you'll have to determine your risk tolerance before you invest.
   
• Single-premium vs. multiple-premium annuities. Single-premium annuities require applicants to make a large upfront payment, which can be very difficult for some investors. However, these options allow faster access to your invested funds.
  
  Multiple-premium annuities offer you the opportunity to save over time by paying periodically, making them a good long-term option. But unlike a single-premium annuity, you generally won't be able to access your contributions for many years to come.
   
• Immediate vs. deferred annuities. Immediate annuities offer the option to receive income within a year or two of your investment. This may be an advantage for those facing imminent retirement. However, funding them typically requires a large sum of cash up front. Deferred annuities offer more time to save and to profit from your investment. Your money will grow over a period of months, years or even decades. However, it won't be accessible to you right away.
   

Before you commit to an annuity contract that could last decades, carefully research your options. Make sure the type of annuity you choose will help you build wealth in a way that aligns with your long-term financial goals.