Annuities 101: a foundation for protected income

If you have spent years building a business, a 401(k), or both, you already know how to grow money. The question that shows up later is different. Which dollars have to be there every month, even in a year the market does not cooperate?

That is the only reason I talk about annuities. Not to replace what you already own. To cover the bills that do not care what the market did. This is the plain version. It is not a product pitch.

What you are actually buying

An annuity is a contract with an insurance company. You put in a lump sum, or you pay in over time. They credit interest the way the contract says. If you turn on an income option, they pay you for a set number of years, or for as long as you live.

People hear “annuity” and picture a brokerage account. It is not one. You are not buying shares of anything. You are buying a promise from a company. The promise is only as good as that company. It is also not a bank account. The FDIC is not standing behind it.

Social Security, a pension, and lifetime income from an annuity. Those are the three paychecks that can be set up so they do not run out while you are living.

The growth can wait on the tax

Inside the contract, the growth is generally not taxed until you take money out. If the dollars going in are not already sitting in an IRA or a workplace plan, there is no annual IRA contribution cap on them. That is useful if you got a late start, or if you sold a business and have more cash than a retirement account will take.

A rollover from a 401(k) or an IRA is a different animal. That money already lives under those account rules, and moving it does not hand you a fresh contribution. Insurance companies also decide how much premium they will accept. “No IRS cap” does not mean they will take any check you write.

A bad market year does not cut a fixed rate

On a fixed annuity, the company tells you the rate and the term up front. If the market drops 20 percent next year, that credited rate does not drop with it. For a lot of households, that is the whole point. One piece of the plan that is not watching the news.

Cashing the whole thing in early is a different story. Most of these contracts charge you to leave during the first several years. Some adjust the value if interest rates have moved. And the interest you pull out is generally taxable. The rate is real. A free exit on Tuesday is not. If the company cannot pay, the rate on the paper does not matter either.

A paycheck that can last as long as you do

You can turn some contracts into a check that lasts as long as you live. A joint option lasts as long as either spouse lives. Live long enough and the company can end up paying you more than you put in. That is the trade. You are handing them the risk that you live to 95. The check is usually smaller than what a strong market might have paid. You are buying a floor, not the biggest number on a spreadsheet.

Not every annuity does this. A MYGA is a locked rate for a term, not a lifetime paycheck by itself. What a MYGA is, and what a fixed indexed annuity is, are laid out in plain English further down. Lifetime income is a choice, and only on a contract that offers it. How I put that floor together is on the guaranteed retirement income page.

You do not have to protect every dollar

A lot of the people I sit with have their money in one place. The business. Company stock. A brokerage account that has treated them well. That works while the paycheck is still coming in. It gets uncomfortable if the groceries, the property tax, and the health insurance all depend on that same pile having a good year.

You do not need to protect every dollar. You need to protect the dollars the household actually lives on.

How big that piece should be is a planning question, not a sales question. I would rather tell you it is smaller than you expected than hand you a contract you do not need. Whatever the size, the income is the insurance company’s promise. No federal agency insures it.

When I would look, and when I would not

I will tell you when I do not think you need one. The conversation is worth having if Social Security will not cover the basics, if a long life is likely and running out is the risk that bothers you, or if you want part of the savings out of the market’s way.

• Skip it if you need every dollar liquid.
• Skip it if the surrender years run past the day you might need the cash.
• Skip it if the only number you liked was on an illustration, and the contract does not actually promise it.

Where the money can come from

People fund these from a 401(k), an IRA, a savings or brokerage account, an inheritance, or the sale of a house or a business. Where it came from decides the tax. Qualified money stays qualified. Money you already paid tax on grows tax-deferred, and generally only the gain is taxed, as ordinary income, when it comes out. You do not pay tax a second time on the dollars you put in.

What changes the size of the check

Once income starts, three things do most of the work. How old you are. Which income option you picked. And what the contract is worth that day. On many contracts, gender is in the math too. Wait longer and the check is usually bigger. Cover both lives and the check is usually smaller, because the company may be paying across two long retirements instead of one.

Income now, or income later

You pick the start date. You also pick monthly, quarterly, or once a year.

An immediate annuity is the straightforward one. A lump sum goes in. Income can start within a year. I see it used by someone who is already retired and wants another layer on top of Social Security, or a pension, and does not want to wait around for it.

A deferred annuity waits. It grows first, and you name the year the income starts. Waiting usually buys a larger check later. That is the shape of most of the fixed and fixed indexed contracts I place. The differences are on the fixed and fixed indexed annuities page.

What your family gets

The worry I hear is that the money vanishes if you die. On a lot of deferred contracts, whatever value is left can still go to your beneficiaries, even after the income has started — as long as you did not pick an option that spends the account down to a pure lifetime payment with nothing behind it. Closer to an IRA passing a balance than to a pension that simply stops.

Some contracts will sell you a larger death benefit. That costs extra. Do not mix it up with a lifetime income rider. One is the check while you are here. The other is what is left when you are not. The contract has to say which one you have, and what a spouse or a child actually receives once the income is turned on.

The two kinds I use

When I say annuity, I mean one of two contracts. Both are insurance. They are not the same product, and they do not do the same job. Here is each one, in plain English.

What a MYGA is

MYGA stands for multi-year guaranteed annuity. It is a fixed annuity with a rate you can read on day one, locked for a set number of years — often three, five, seven, or ten.

You give the insurance company a lump sum. They credit that stated rate for the whole term. If the stock market falls, the rate does not fall with it. When the term ends you can take the money, renew at whatever rate they offer then, or move the contract. Interest generally is not taxed until you take it out.

People set a MYGA next to a CD because both sound like “a known rate for a known number of years.” They are not the same thing. A CD is a bank deposit. A MYGA is an insurance contract. The promise is the company’s, not the FDIC’s. Leave before the term is up and a surrender charge can apply. A MYGA is a place to hold money for the term. It is not, by itself, a paycheck for life. The rate and tax comparison, with numbers, is in MYGA rates and CDs.

• You know the rate before you sign.
• You know how many years that rate lasts.
• A down market does not cut the rate.
• It is a holding period, not a lifetime paycheck on its own.

What a fixed indexed annuity is

A fixed indexed annuity — often shortened to FIA — is also a contract with an insurance company. You are not buying stocks. The premium is not invested in the S&P 500, or in any index. The contract can credit interest based on how an index moves, often the S&P 500, under rules that are written down before you sign.

Those rules put a lid on the credit: a cap, a participation rate, a spread, or some mix of those. In a good year you may get some of the index’s gain. You will not get all of it. In a bad year that year’s credit can be zero. Zero means the index did not take principal away. It does not mean you earned something. Withdrawals, a rider charge, and a surrender charge can still reduce what you have.

People choose one when they want a chance at more interest than a locked MYGA rate, without a market loss inside the contract. Many of these contracts can also add a lifetime income rider. That rider is optional, and it costs money. The number the check is figured from is often not the same number as the cash you could walk away with.

On many of those riders, the income base can step up while you wait, under that rider’s own rules. Once the lifetime withdrawals start, a later down year in the index does not cut the check. Waiting does not raise every contract by the same percent every year. Read the formula. If you do not need the income, do not pay for the rider.

• Interest can be linked to an index, with a cap, a participation rate, or a spread.
• A down index year can credit zero. It does not mark the account down the way a brokerage account would.
• You do not own the index. An up year is not the index’s full return.
• A lifetime income rider is optional. It has a cost, and the income base is not the same as cash value.
• Interest is generally not taxed until you take money out.

Side by side

I stick to fixed and fixed indexed annuities. The point is protection, not a bet inside the contract.

Why I do not use variable annuities

A variable annuity puts the money in investment subaccounts. That is market risk, and it is sold with a securities license. I am licensed for fixed insurance and fixed annuities. I do not recommend variable contracts. If you want market risk, you already have places to take it. In this shop, the annuity is the part that is supposed to hold still.

One warning covers all of them. Take money out early, or take more than the free amount, and a charge can apply. Take the gain out before 59½ and the IRS can add a penalty on top of the income tax. Before anyone buys, we line the surrender years up with the year you might actually need the cash.

The five things people worry about

Aren’t they expensive? Some have no annual fee. Others charge for an extra, usually an income rider or a larger death benefit. Those are different products. The question worth asking is the simple one. What am I paying for, and is that the thing I came in to buy?

Are the fees hidden? If a charge exists, it has to be in the paperwork. On the contracts I use, that means the contract, the disclosure, and the illustration. Not a prospectus. These are not securities. Ask to see the surrender schedule, any rider charge, and any market-value adjustment. Then ask what each one does if you take income, if you die, or if you leave.

Does your commission come out of my money? On most fixed and fixed indexed annuities, the insurance company pays me. It is not skimmed off the top of your premium the way a front-end fund load is. It is still how I get paid, and you should ask. Then compare the contract with leaving the money where it is. How I am paid does not make the contract a good idea. It also does not, by itself, make it a bad one.

I can’t touch the money. You can usually touch some of it. A lot of contracts let you take about 10 percent a year with no surrender charge. Whether that 10 percent is of the premium or of the account value is in your contract, not in a rule of thumb. Take more than that during the surrender years and a charge can apply. And “no surrender charge” does not mean “no tax.”

They’re too confusing. The decision is smaller than the packet. Do you want a stated rate, or a chance at index interest that cannot go negative? Do you need a check this year, a check later, or just a place for the money to sit? The extras are optional. If you cannot explain one in a sentence, do not buy it.

The worries are fair. They are usually about a contract you have not read yet.

Bring the rest of your team

If you already have a CPA, an estate attorney, or an investment adviser, good. I should be adding a piece, not handing you a second plan the rest of your team has never seen. A short conversation is usually enough to know whether protected income belongs in the picture at all. If it does, we can talk about how much. I meet by phone, by video, or at your home.

A few places to look before we talk

These are free, public, and none of them knows your contract. I am not endorsing them. They just answer questions I get every week.

What I will and will not do

I am independent. I am not stuck with one company’s product. The work is to set two or three fixed or fixed indexed contracts next to the income you need, the year you need it, and what you want left for a spouse or for the kids. Sometimes the answer is a contract. Sometimes the honest answer is to leave the money alone. I will tell you which one it is.

The right annuity is not a brand name. It is the paycheck your plan actually needs, from a company that can pay it.

This is education, not a recommendation, and not tax, legal, or investment advice. It does not describe any specific product. It is adapted from the Alliance for Lifetime Income consumer guide “Check Off the Basics: A Guide to Planning for Essential Expenses in Retirement” (ProtectedIncome.org) and rewritten in my own words. Any guarantee depends on the insurance company’s ability to pay its claims. Annuities are not bank deposits and are not insured by the FDIC or any government agency. Leave during the surrender period and you can get back less than you put in. Gain you withdraw is generally taxed as ordinary income, and a taxable withdrawal before 59½ can bring an extra 10% federal tax penalty. The links above are for convenience, not endorsements. I am a licensed insurance professional. I do not give legal or tax advice, sell securities, or manage portfolios. Ted Byrer, Byrer Wealth Management, LLC. Indiana Resident Insurance Producer License #2767910, National Producer Number #1498594.