An annuity is an investment contract between you and an insurance company that allows you to deposit a certain amount of money from which the insurer makes payments to you over a period of time spelled out in the contract. Annuities are not life insurance policies—although they can only be underwritten by insurance companies—nor are they savings accounts, because there are usually tax penalties for withdrawals before age 59½. Instead, they are unique, long-term financial vehicles that can help you plan for retirement because they offer a guaranteed stream of income.
Here are a few of their special features:
Earnings are tax-deferred—you don't pay federal income tax on gains on the funds until you begin to withdraw money.
They can provide retirement income for life. When you purchase them, you can choose payouts that last a lifetime or a time period that you specify.
- They can provide financial protection to your beneficiary if you die before receiving your complete payouts.
Deferred and Immediate Annuities
There are two major types of annuities: deferred and immediate. As its name suggests, income generated from a deferred annuity is deferred to a future date. Deferred annuities can be funded in one of two ways—either as a single payment, called a Single Premium Deferred Annuity (SPDA), or with systematic payments over a period of years, called a Flexible Premium Deferred Annuity (FPDA). During the accumulation period, earnings build up tax-deferred on the premiums you deposit into your annuity. Payouts—know as annuitization—begin at a time you specify.
Immediate annuities, on the other hand, provide you with an immediate income because they convert your initial lump sum of money into a series of periodic payments that begin within one year of when you make your first deposit. These payments continue for as long as you live, or for a fixed period of time, such as 10, 20 or 30 years.
Fixed and Variable Deferred Annuities
Deferred annuities can be further divided into two types, fixed and variable. Fixed annuities earn a fixed rate of interest, guaranteed for a specific period, by the insurance company. (Thus, the insurance company assumes the financial risk.) With a variable annuity, your premiums are placed in investment options, which you choose, called subaccounts. These subaccount investments are similar to mutual funds in many respects and will determine the value of your account. (Thus, you assume the financial risk.) You can invest in a stock, bond or other account, or into a fixed account, which may have a guaranteed minimum rate of interest.
In addition to tax-deferred growth, annuities also offer a variety of unique payout options. Popular choices include:
Period Certain, a guaranteed income over a period of years you choose. (Typical choices are 5, 10, or 20 years). If you don't survive the term, your beneficiary will receive the income for the remainder of the term.
Life Income with a Period Certain, which provides a guaranteed income for the number of years you choose or for the rest of your life (whichever is longer).
Joint Life and Survivorship, which pays as long as either you or the survivor (you've named) is living, thus providing income beyond the lifetime of a couple.
- Cash surrender.
What to Consider before Buying an Annuity
Experts suggest you consider the following before investing in an annuity.
Make sure the insurance company you're considering buying an annuity from is reputable and financially strong. Check the organization's professional affiliations, ratings and investment holdings.
Have your insurance advisor answer any questions before you buy.
To learn more about how annuities can create a guaranteed stream of retirement income you can't outlive, click here.
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