An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date.
Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay your beneficiary a specified minimum amount, such as your total purchase payments. While tax is deferred on earnings growth, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates. If you withdraw your money early from an annuity, you may pay substantial surrender charges to the insurance company, as well as tax penalties.
There are generally three types of annuities — fixed, indexed, and variable. In a fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.
In an indexed annuity, the insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance.
Types of Annuities:
Immediate Annuities
In an immediate annuity, the investor begins to receive payments immediately upon investing. This is for investors that need immediate income from their annuity. When you purchase an immediate annuity you can choose between payments for a certain period of time (typically five to twenty years – “period certain”), payments for the rest of your life and/or your spouse’s life, or any combination of the two. You can even choose between a fixed payment that doesn’t vary or a variable payment that is based on market performance.
Deferred Annuities
In a deferred annuity, you typically receive payments starting at some future date, usually at retirement. However, most deferred annuities allow for systematic withdrawal payments beginning thirty days after the purchase of your annuity, up to 10% per year, in most cases. With a deferred annuity you can invest either a lump sum all at once, or make periodic payments, either fixed or variable. Those funds grow tax-deferred until you’re ready to begin receiving payments. Deferred annuities make up a large majority of all annuity sales in the United States, and are the type of annuity that Annuity FYI generally recommends if you do not need immediate income from your annuity.
Investment type — fixed or variable:
The next decision to make is the investment type best suited to your needs: fixed or variable.
Fixed Annuities
A fixed annuity is a contract with an insurance company. You give them your money to manage, and in exchange they pay you a guaranteed return.
Deferred Fixed Annuity
With a deferred fixed annuity, you receive a guaranteed amount of interest which accumulates inside of the annuity contract. The interest is tax deferred, so no income taxes are paid until you take a withdrawal.
A deferred fixed annuity may have high surrender charges that are in place to prevent you from withdrawing money for a period of 5, 10, or more years. Most deferred fixed annuities have a feature which allows you to access up to 10% of the contract value each year without having to pay the surrender charge.
Immediate Fixed Annuity
With an immediate fixed annuity, you exchange your lump sum of money for a guaranteed stream of income from the insurance company. Once fixed annuity payments begin, they do not change, which means they will not increase with inflation. Keep in mind, once these annuity payments begin, you no longer own, or have access to, the principal. You simply have a right to the income they have promised you.
Once you choose to annuitize your contract, which means you trade in your lump sum for a guaranteed stream of income, you will have to choose the term of your payments.
When considering a fixed annuity, compare it with alternatives that may offer more flexibility, such as certificates of deposits, or a ladder of high-grade bonds that allow you to keep your principal with minimal restrictions on accessing your money.
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Variable Annuities
A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. As far as safety, then, the difference between investing in a fixed annuity vs. a variable is rather like the difference between investing in a bank CD vs. a mutual fund.
A fixed annuity provides more security of principal than a variable annuity, but has limited upside potential. When you invest in a variable annuity, you accept more short-term volatility in that the value of your investment will fluctuate with the stock and bond markets.
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