Annuity contracts are insurance policies designed and sold by life insurance companies. Unlike life insurance, annuities insure your income during retirement. The annuity may pay an immediate benefit payment, or defer the payment until a time you choose. If you defer the benefit payment from an annuity, you are investing in a deferred annuity. This annuity may be drawn against for any reason, but you must know the rules for doing so.
There are two types of annuities that you may choose from. A fixed annuity pays a fixed rate of return on money you deposit into the annuity. A variable annuity is the second type of annuity. This type of annuity does not make any guarantees on interest crediting. Both types of annuities offer two ways of making deposits. The annuity may be set up as a single pay annuity. This means that only one contribution amount is allowed into the annuity. Alternatively, the annuity may be set up as a savings annuity. A savings annuity accepts multiple contributions over time.
The significance of these deferred annuities is that your savings may be withdrawn during your lifetime for any reason. These annuities are considered by the IRS to be a form of retirement savings and are treated similar to retirement accounts. But, with some types of retirement accounts, access to the funds is difficult if not impossible. Insurance companies allow you to withdraw money from these accounts within limits and do not place restrictions on any age or reason for the withdrawal.
The benefit of being able to withdraw money from your annuity is that you gain access to funds when you need them. When the money is in the annuity account, it is exempt from income taxes. This allows your savings to grow faster than it otherwise would be able to grow if it were taxed every year a gain was realized.
The disadvantage to annuities is that, while you may make withdrawals at any age and for any reason, the withdrawals may come with penalties. First, the insurance company allows withdrawals up to a certain limit. This is normally 10 or 20 percent of the total annuity account balance. Any amount in excess of this amount incurs a penalty that is specified in the contract. The IRS imposes a penalty as well. The IRS assesses a penalty of 10 percent on any amount withdrawn prior to age 59 1/2. The IRS does this since it treats annuities as a form of retirement account. In addition to any penalties, you must pay ordinary income tax on any gains you withdraw from your policy. The IRS considers withdrawals from your annuity to be a withdraw of investment gains first and investment principal last.
Before making withdrawals from your annuity, consider using other savings first. Annuities are long-term contracts designed to provide retirement income to you. Because of the possible penalties you face for making withdrawals, withdrawals from an annuity may be an expensive way to access your savings. Instead of withdrawing money from your annuity, try to use up the money in your savings account, money market or some other non-retirement account prior to using money designated for your retirement. This will keep your retirement savings intact and provide you with potentially more retirement income in the future since you are not withdrawing and spending it now.