Annuities can seem confusing, especially when you hear terms like “ordinary annuity” and “annuity due.” But understanding the difference between these two types of annuities is key if you’re considering using one for retirement income or other financial goals. This guide will explain what ordinary annuities and annuities due are, how they work, and the main differences between them.
What is an Annuity?
An annuity is a financial product that provides a series of payments for a set period of time (or for life) at regular intervals. With an annuity, you make either a lump-sum payment or a series of payments to the insurer. In return, they provide regular income payments on a monthly, quarterly, or annual basis.
Annuities can provide retirement income that you cannot outlive. There are several different types, but the two most common are fixed and variable annuities.
What is an Ordinary Annuity?
An ordinary annuity provides income payments at the end of each period. For example, if it pays $1,000 monthly for 10 years, you would receive your first payment at the end of month 1, your second payment at the end of month 2, and so on.
The formula to calculate the present value of an ordinary annuity is:
PV = PMT [(1 – (1 + r)^-n) / r]
- PV = Present value of the annuity
- PMT = Payment amount
- r = Interest rate
- n = Number of payment periods
What is an Annuity Due?
An annuity due provides income payments at the beginning of each period. Using the same example, you would receive your first $1,000 payment at the beginning of month 1, your second payment at the beginning of month 2, and so on.
The formula to calculate the present value of an annuity due is:
PV = PMT [1 / r – (1 + r)^-n / r]
The variables mean the same as above.
Key Differences Between Ordinary Annuity and Annuity Due
The main differences between ordinary annuity and annuity due are:
- Payment timing – Ordinary annuities pay at the end of each period, while annuities due pay at the beginning.
- Present value – Annuities due have a higher present value because payments are made earlier.
- Interest accumulation – Annuities due allow more time for interest to accumulate on payments.
Which is Better – Ordinary Annuity or Annuity Due?
Which type of annuity is better depends on your specific financial situation and goals.
Annuities due provide more value if you maximize returns and have a longer timeline. But ordinary annuities get payments started right away, which can be advantageous if you need income immediately.
Consider your needs, timeline, and risk tolerance. Annuities are complex, so consult a financial advisor when deciding.
Frequently Asked Questions
What are the payment frequencies for annuities?
Most annuities pay income monthly, quarterly, or annually. You choose the frequency when purchasing the annuity.
What are the main types of annuities?
The two primary types are fixed and variable annuities. With fixed annuities, you receive a guaranteed minimum interest rate. Variable annuities invest their funds in subaccounts, so your income payments depend on the performance.
What are the benefits of annuities?
Key benefits are providing guaranteed lifetime income, tax-deferred growth, and death benefit payouts to beneficiaries. Annuities can also help limit your exposure to market volatility.
How are annuity payments taxed?
If you purchase your annuity with pre-tax dollars, income payments will be fully taxed. If you use after-tax dollars, only the interest portion of payments is taxable.