Your retirement plan may consider multiple sources of income. An annuity is one possible way to plan for income in retirement. Learn more about how annuity investments could fit with your financial plan.
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What is an annuity?
An annuity is a contract with a life insurance company. You deposit a lump sum of money, and they agree to pay you a guaranteed income for a set period of time — or for the rest of your life.
This can bring peace of mind, since once you buy an annuity, you don’t need to make any further investment decisions about the money you’ve deposited. And you know exactly how much you’re going to receive every month in income.
There are two types of annuities and a few different ways to purchase them.
1. Term-certain annuity
A term-certain annuity gives you a guaranteed regular income for a set number of years (the term). Term-certain annuities bought with money from an RRSP or RRIF must extend to age 90. If you die before the end of the term, your payments will continue to go to your estate.
2. Life annuity
A life annuity gives you a guaranteed regular income for life. Payments usually stop when you die, and no money will go to your estate. You may choose to add an option that allows your spouse, beneficiary, or estate to continue to receive your payments after your death.
Learn more about annuity options and how they can impact your investment returns.
You can use an annuity for other financial planning goals like providing money for your beneficiaries or estate, or leaving a gift to charity. For example, an insured annuity gives you a steady stream of income during your lifetime and pays your beneficiaries a lump-sum amount at your death.
Learn more about using annuities for other financial planning goals.
How do you buy an annuity?
For example, when you close your RRSP (which must be done before you turn 71), you have the choice to transfer this money to an annuity or a RRIF, or to claim it as taxable income.
When you purchase an annuity, the money is returned to you in regular payments, with interest. You can choose to receive payments for a set number of years or for the rest of your life.
There are three ways to buy an annuity:
- In-person from a licensed insurance agent or broker
- Online or by phone from a broker or insurance company
- From a financial advisor who is licensed to sell insurance
Some investment firms may also have a licensed broker on staff who can sell annuities.
There are six steps to consider if you want to buy and annuity:
1. Decide for how long you want to receive payments
It’s important to know your answer to this question before you start talking to annuity providers. You can choose a term-certain annuity that makes a specified number of payments over a set period of time. Or you can choose a life annuity, which will give you a regular income for the rest of your life.
2. Decide what options you need
Annuities will let you add options such as a guaranteed benefit period, which means the payments from a life annuity will continue to your spouse, beneficiary, or estate after you die. Or you can choose an indexing option, which increases your payments automatically to keep up with inflation. Your options will depend on your life situation and how you’d like your annuity income to be managed after your death.
3. Compare annuities and providers
Compare costs and understand how they will affect your annuity income. This includes any up-front commissions or sales fees. Buy only from a strong life insurance company with a high credit rating. In general, the higher the credit rating, the more likely it is in the opinion of the credit rating agency that a company will meet its payment obligations.
Find out how long the company has been in the annuity business and its track record. Since an annuity is a long-term contract, you want to make sure the life insurance company will be around as long as you are.
4. Decide on how often you want to receive payments
You can receive your payments monthly, quarterly, semi-annually or annually. Choose what’s right for you based on your lifestyle and your expenses.
5. Choose a beneficiary
This is the person who will get any annuity payments that continue after your death.
6. Review and sign the contract
Read the application and other papers with care before you sign. Do the same with the contract when it arrives. File your contract with your other important legal papers.
Guaranteed minimum withdrawal benefit (GMWB) – products are a type of annuity that provides guaranteed retirement income that can increase with investment gains in your portfolio and with certain bonus features. Learn more about GMWB products.
How do annuity payments work?
You can receive monthly, quarterly, semi-annual, or annual payments. Your annuity income is calculated at the time you purchase the annuity. Once you buy an annuity, you can’t make any changes to it. Your regular payment amounts are locked in, and you can’t change them for any reason.
There are six factors that can affect your annuity income:
1. Current interest rates
If interest rates are high when you buy your annuity, your annuity payments will be higher than if interest rates were low. That’s because the financial institution predicts it can earn more by investing your money.
2. The amount you deposit
The more money you put into your annuity, the more you get back as income.
3. Your age
The older you are when you buy the annuity, the higher your annuity payments will be. That’s because you’re not expected to live as long.
4. Your gender
Women get less money than men of the same age because they are expected to live longer.
5. The length of time the payments are guaranteed
You choose the number of years you receive payments with a term-certain annuity. The shorter the term, the higher the payments. If you have a life annuity, you can arrange for your annuity payments to continue to your spouse, your dependent children, or your estate after you die. The longer you want payments to continue after your death, the less you get each month while you’re alive.
6. The options you add
You get the highest income with a basic annuity that covers only you. Any options you add (like a joint-and-last survivor option) will lower the amount of your payments. That’s because these extras increase the costs to the insurance company.
If interest rates are low when it’s time to convert your RRSP into an income option, you may want to delay buying an annuity. Instead, you can open a RRIF. When interest rates rise, you can then use your RRIF to buy an annuity.
Some life annuity providers will also factor health into an annuity quote if you have a serious medical condition. This may mean your annuity payments will be higher if your life expectancy is shorter.
What are the fees for an annuity?
It’s important to understand the fees you pay for any investment.
You pay an up-front commission or sales charge when you buy an annuity. The commission can be up to 3% of the lump sum you’re depositing.
Other fees and costs, such as administrative charges and the costs of options, are factored into the calculation of your annuity payments. You won’t see these costs broken out anywhere.
If you’re buying an annuity at the same financial institution where you have your RRSP, ask them if they’ll waive the sales commission on the annuity.
How is your annuity income taxed?
The tax you pay on your annuity income depends on what source you used to originally buy the annuity.
- If you used money from a pension plan RRSP, or RRIF – Your annuity payments will be fully taxed. That’s because you’re buying the annuity with pre-tax dollars.
- If you buy an annuity with money from a non-registered account – You’ll only pay tax on a portion of the payments you receive. That’s because you have already paid tax on this money.
Here’s how tax on annuity payments works:
- To make your regular payments, the annuity provider pays out some of the income it earns investing your money, together with some of your original principal.
- In the early years of your annuity, the Canada Revenue Agency (CRA) considers most of the income you get as interest for tax purposes. That means it will be fully taxed.
- In later years, the income you receive is mostly from your principal. Since you have already paid tax on that money, your taxes go down over time.
If you’re over age 65 and do not have a company pension plan, you may be able to claim the pension income tax credit. This means you won’t be taxed on the first $2,000 of annuity income each year.
Deferring tax on annuity income
One way to defer paying tax on your annuity income is to buy a prescribed annuity with after-tax money. The annuity provider will include the same amount of principal and interest for each payment. This evens out the portion of your payment that is subject to tax, and means you pay less tax in the early years.
How is your annuity protected?
If your annuity provider goes out of business, your annuity is insured up to certain limits. The first $2,000 per month of your annuity income is insured at 100%. Amounts above this are insured at 85% if the firm is a member of Assuris.
The insurance that covers your annuity is automatic. You don’t have to do anything, and you don’t have to pay anything extra to get it.
An annuity is a contract with a life insurance company.
- You can choose to receive annuity income for life, or for a set number of years.
- Your annuity income is calculated at the time you buy the annuity. It’s based on a number of factors – the most important ones are interest rates and your life expectancy.
- You can add options to your annuity. Every option you add lowers the payments you receive from your annuity.
- Most annuity costs and charges are factored into the calculation of your annuity payments.
- Like any investment, it’s a good idea to shop around and compare fees and rates.