Though some people stay away from annuities because of the complexities involved, one major benefit of annuities is that they allow your money to grow on a tax-deferred basis. But if you're going to invest in one, it's important that you understand how annuities work. Here are four rules to consider before you put money into an annuity.
1. You can't just cancel an annuity
An annuity is a contract, which means that if you decide to back out, you're likely to face surrender charges. Surrender charges are calculated as a percentage of the amount withdrawn from an annuity. While these charges can vary, they typically start at 7% during the first year of the contract and decline by 1% each year during the surrender period, which can last six to eight years, sometimes more.
However, there are exceptions. Often, annuity contracts will let you withdraw a portion of your account value each year -- usually up to 10% -- without incurring a surrender charge. Furthermore, the surrender charge may not apply under certain circumstances, such as if the contract owner dies, becomes terminally ill, or is confined to a nursing home or long-term care facility.
Furthermore, you can usually get out of an annuity contract if you change your mind right away. Many annuities come with a free-look provision that allows holders to terminate their policies without paying surrender charges if they act within 10 to 30 days after signing their contracts.
2. You can't just withdraw your money whenever you'd like
The purpose of an annuity is to provide income in retirement. Even if you're well past your contract's surrender period, if you take money out of an annuity before you reach the age of 59 1/2, you'll be assessed a 10% early withdrawal penalty -- the same penalty you'd face for making early withdrawals from a traditional IRA or 401(k) plan. You'll also be charged taxes on your investment gains. There are some exceptions where this penalty won't apply, such as if the contract holder dies or becomes permanently disabled, but generally speaking, it's best to hold off on taking money out of an annuity until 59 1/2.
3. You may be subject to required minimum distributions
While non-qualified annuities (those purchased with after-tax dollars) don't come with required minimum distributions, qualified annuities -- the type purchased with pre-tax dollars and held in accounts like IRAs -- are subject to the same required minimum distributions as other qualified retirement accounts. Failing to take a required minimum distribution could trigger some serious tax consequences. In fact, you might face a tax penalty equal to 50% of what your minimum distribution should have been. If you do hold an annuity in a retirement account other than a Roth IRA, make sure to understand when you need to begin taking distributions.
4. Your withdrawals are taxable
Withdrawals from qualified annuities are taxed as ordinary income in the same manner as other traditional retirement account distributions. Non-qualified annuities, meanwhile, are generally taxed on a last-in, first-out basis. What this means is that when you take withdrawals, the funds taken out will be deemed to have come first from earnings, which are taxed as ordinary income. This rule will apply until the value of the annuity falls below the total amount of premiums you initially put in.
However, if you annuitize your contract (convert your annuity to a series of guaranteed payments), your payments will essentially be divided into two parts: initial contributions and investment gains. At that point, only your gains will be taxed as ordinary income; the remainder of your payments will be considered a return of premium and won't be taxed.
Annuities aren't for everyone, but if you're interested in going that route, be sure to delve into the nuances of how they work. Under the right circumstances, an annuity can be a good way to secure an income stream in retirement, but make sure you know what you're getting into before you sign a contract.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.