What are Annuities?
An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments. Similarly, your payout may come either as one lump-sum payment or as a series of payments over time.
Why do people buy annuities?
People typically buy annuities to help manage their income in retirement. Annuities provide three things:
- Periodic payments for a specific amount of time. This may be for the rest of your life, or the life of your spouse or another person.
- Death benefits. If you die before you start receiving payments, the person you name as your beneficiary receives a specific payment.
- Tax-deferred growth. You pay no taxes on the income and investment gains from your annuity until you withdraw the money.
What kinds of annuities are there?
There are three basic types of annuities - fixed, variable and indexed. Here is how they work:
- Fixed annuity- The insurance company promises you a minimum rate of interest and a fixed amount of periodic payments. Fixed annuities are regulated by state insurance commissioners. Please check with your state insurance commission about the risks and benefits of fixed annuities and to confirm that your insurance broker is registered to sell insurance in your state.
- Variable annuity- The insurance company allows you to direct your annuity payments to different investment options, usually mutual funds. Your payout will vary depending on how much you put in, the rate of return on your investments, and expenses. The SEC regulates variable annuities.
- Indexed annuity- This annuity combines features of securities and insurance products. The insurance company credits you with a return that is based on a stock market index, such as the Standard & Poor’s 500 Index. Indexed annuities are regulated by state insurance commissioners.
What are the benefits and risks of variable annuities?
Some people look to annuities to “insure” their retirement and to receive periodic payments once they no longer receive a salary. There are two phases to annuities - the accumulation phase and the payout phase.
- Accumulation phase - During the accumulation phase, you make payments that may be split among various investment options. In addition, variable annuities often allow you to put some of your money in an account that pays a fixed rate of interest.
- Payout Phase - During the payout phase, you get your payments back, along with any investment income and gains. You may take the payout in one lump-sum payment, or you may choose to receive a regular stream of payments, generally monthly.
All investments carry a level of risk. Make sure you consider the financial strength of the insurance company issuing the annuity. You want to be sure the company will still be around, and financially sound, during your payout phase.
Variable annuities have a number of features that you need to understand before you invest. Understand that variable annuities are designed as an investment for long-term goals, such as retirement. They are not suitable for short-term goals because you typically will pay substantial taxes and charges or other penalties if you withdraw your money early. Variable annuities also involve investment risks, just as mutual funds do.
Some other benefits:
- Tax deferral- there is no income or capital gains taxes on the investment buildup.
- Creditor protection- creditor claims are limited to the amount of the annuity payments.
- Multiple investment choices- annuity companies offer a wide range of investment strategies from which to choose from during the accumulation phase.
- Tax-free transfers among investment choices- changing underlying investments in an annuity is not normally subject to income tax.