An annuity is a contract between you and an insurance company. The contract stipulates payments of a set amount of money over a specified time. Annuities are often used as an investment for retirement planning because it provides a guaranteed stream of income. On a single premium annuity you contribute a lump-sum payment to the annuity at a set interest rate. Then you begin to receive periodic payments, usually monthly, for the specified period. There are several pros and cons to investing in a single premium annuity.
One of the positive features of a single annuity is the guaranteed rate. Investors do not have to worry about their investment fluctuating over time because the annuity contract guarantees a rate, usually somewhere between 4 percent and 8 percent, for a set period. Although there are other investments such as bonds, treasuries, and CDs that offer a guaranteed rate, the overall yield is often lower than in an annuity.
On a single premium annuity, within the contract there is a limited period for the initial guaranteed rate. As a result, an investor has the option to use the annuity bailout provision. This provision is protection against instability of rates once the guarantee period ends. The bailout provision generally protects against rate drops of more than 1 percent of the original rate by giving you the option to cash out of the annuity contract penalty free. You then have the option to reinvest your money in another annuity or an entirely different investment of your choosing.
A con to investing in annuities is a potential IRS tax penalty for early withdrawal. Since, these investment vehicles are considered a retirement investment, taking money out of the annuity prior to the age of 59 ½ results in a 10 percent tax penalty, in addition to your ordinary tax rate. However, only the income earned on the annuity is subject to the penalty, not the original principle. Therefore, there is a potential to make less money than you intended, but not actually lose your original investment. Exceptions to the 59 ½-withdrawal rule include when the holder of the annuity dies or become disabled or if you choose distribution of the annuity within one year of signing the contract.
A minor disadvantage of the single premium annuity is you can only make one lump-sum contribution. After that, the contract prohibits you from re-investing in the same contract. This provision gives the insurance company the ability to fulfill its contract obligation based on the guaranteed rate promised and the amount of the initial contribution. However, if an investor finds he has additional funds to contribute to an annuity, he is welcome to purchase additional annuity contracts at the current going rates.