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Annuity basics

Types of Annuities

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Annuity Glossary

Accumulation Phase/Period - the time when you are able to add money to your annuity and accumulate assets (gains) tax-deferred. This is also the time before you are eligible to receive the final benefit.

Annuitant - A person who purchases an annuity and is entitled to receive, or receiving payment from an annuity.

Annuitization - When the annuity is converted from an account that accumulates funds to an account that pays out to you periodically. "Cashing-in" your annuity.

Annuitization Phase/Period - The period that you receive payments from an annuity. Either a fixed amount of time or until you die.

Death Benefit/Provisions/Proceeds - The amount paid out to a beneficiary upon the death of the annuity owner. Generally includes the account balance and possibly an insurance benefit.

Deferred Payout - When the annuity is paid out at a later date. You would purchase the annuity a period of time (months/years) ahead of the date you want to start receiving payments. You are not taxed for money deposited into the annuity during this period.

Distribution Phase/Period - The period of time when you are receiving payouts from your annuity. Payouts can be fixed or variable.

Exclusion Ratio - The computation to figure out the amount of each payment (in the distribution phase) that WILL NOT be taxed. This is determined by dividing your investment (money you put into the annuity) by the total amount your would expect to receive during the payout period. In short, you will not be taxed on your initial investment, only the profits gained from your annuity. An in-depth example follows:
You invest $100,000 in an annuity that will pay you $750 a month for life starting at age 62. According to IRS Life Expectancy Tables (see: Appendix C) you are expected to live 22.5 more years. This means your annuity value is $202,500. ($750 per month X 12 months per year X 22.5 years). Your exclusion ratio is $100,000/$202,500 = 49.4% (investment/annuity value=exclusion ratio). This means 49.4% of your payouts will not be taxed, however, the other 50.6% is subject to Ordinary Income Taxation (taxed as if it was a paycheck).

Fixed Payouts - a fixed payout annuity guarantees a fixed income for the rest of your life. If you buy a fixed payout annuity, the insurance company would calculate a guaranteed payment based on things like your life expectancy and how much the insurer feels it can earn by investing your money. This is beneficial because you know how much money you will receive each month. (Opposite; see Variable Payouts)

Flexible Premium - Must be on a Deferred Payment annuity. With this type of annuity, you determine an initial premium to invest. Once that is paid, the annuity allows periodic additional contributions of which the investor chooses the time and amount. When it comes time to annuitize, the payout depends on the total of the initial premium plus additional contributions to the annuity.

Immediate Payout - A type of annuity guaranteed to payout for the rest of your life. You invest a certain amount of money. The insurer determines how much they could make off of your investment and along with considerations of your age and life expectancy they determine how much they will pay out monthly for the rest of your life. If you die shortly after you make the investment, the money will usually go to the insurance company - unless you have a death benefit provision.

Lump Sum - receiving your payout all at once rather than through monthly payouts.

Management Fees - what you pay someone to "manage" your account. Usually less than 1%.

Mortality & Expense Charges (M&E Charge) - a fee that pays for the insurance guarantee, commissions, selling, and administrative expenses of you annuity contract. Usually charged as a percentage value of the investment and usually 1-2%. This fee is usually included in the determination of the periodic interest rate or the payment amount during the distribution phase.

Ordinary Income Taxation on Annuity Gains - simply means that gains on your annuity (anything above and beyond your actual investment) will be taxed as regular income - as if you earned it in a paycheck.

Principal - the initial amount invested.

Single Premium - An annuity purchase with only one premium payment rather than a series of payments/deposits. This can be an immediate annuity or a deferred annuity.

Surrender Fee/Charge - a fee imposed if the annuity is cashed in before a specific period of time, usually anywhere from 1-12 years. Typical surrender fees start around 7% and decrease by 1% every year until it reaches 0%. The charge is made against the value of the investment at the time of surrender and is in place to discourage short-term investing. In other words, the issuer prefers that your annuity be a long-term investment.

Three Way Compounding - the idea that your Principle generates earnings, those earnings generate more earnings, and the money you save by not paying taxes on the invested money generates even more earnings.

Unlimited Deposits - there are no IRS restrictions on how much money you can put into an annuity per year. 401Ks and other retirement plans have an annual cap and therefore are Limited Deposit accounts.

Variable Annuities - a type of annuity in which you spread your premium among investment portfolios consisting of any combination of stocks, fixed income instruments, or money market accounts. The annuity value will the reflect the performance of the investments in these portfolios and is subject to market risk including the loss of the principal amount. The ultimate value of the annuity determines what the payout amount will be.

Variable Payouts - the payouts from variable annuities. They are not guaranteed to be a specific amount as they depend on how the chosen stocks or mutual funds perform in the market.


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