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Before you sign up for an annuity, make sure you understand the various phases of an annuity contract.
In Part 1 of this series we looked at the types of annuities. We then broke down some basic concepts. In this final article, we’ll tackle the different phases of an annuity contract.
Annuities follow similar basic paths, from accumulation to annuitization to payout. The accumulation phase always comes first. It is the period of growth for the annuity that begins after the initial investment is made. During the accumulation phase, your funds are invested in fixed or variable accounts that you choose. Any growth on your investment will accrue tax-deferred. Investments in variable accounts share all the same potential for growth—and, importantly, for losses—that all investments have, including the potential loss of principal. Your investment during this phase is illiquid. You may, at certain points, be able to withdraw your investment, but it will come with an IRS penalty and potential penalties from the annuity holder as well.
The annuitization phase is when the insurance company begins making payments to the investor. In the case of a variable annuity, this is when your investment is converted into annuity units, a portion of the investments the annuity holder has made on your behalf. Note that some types of annuities—which we’ll discuss in the next installment—don’t have an annuitization phase. Hold that thought for now.
The payout phase is the final phase of the annuity, in which payments are made to you based on your ownership of annuity units. This phase can be short, or very long, depending on several factors including the payout amount, the type of annuity and the total amount of investment
You might think that your investment stops earning after the accumulation phase, but it doesn’t. Interest or market gains will continue to accrue during all three phases. If you made an initial investment into a fixed annuity but later made additional deposits, the contract will pay you a guaranteed rate on the initial deposit and all subsequent deposits, both during the accumulation phase and in the annuitization and payout phases. The balance of the funds—less any amount paid to you—will also continue to earn the guaranteed rate until payout is complete and the contract is depleted.
You control when to enter the payout phase of an annuity. When you do, your funds are pooled with other investors’, and the insurance company guarantees an income. The income may be for a fixed period of time or it may be income for life. Your payments will be a combination of principal and interest that you have earned. Those payments will be subject to taxes at ordinary income rates.
How those payments are made, to whom they are made if you pass away, and the timing and variability of those payments depend on the types of annuities, are discussed here.
This is a good time for a reminder that unless you choose a “period certain” or fixed period annuity option, where payments stop after a specified period, the annuity will offer regular income payments for as long as you live—the single biggest advantage to investing in an annuity. This guarantee, however, is based on the claims-paying ability of the annuity provider, so do your homework before choosing. Make sure the company is highly rated and a good match for your financial goals.