What is an Annuity?

Annuities have become a popular choice for those preparing for retirement. The following takes a basic look at what is an annuity.

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An annuity is a type of insurance product that allows you to receive periodic payments for a certain amount of time based on the amount of money you’ve invested.

Your monthly annuity distributions are based on the amount of money you’ve invested in the annuity and the length of your payment period. Annuities come in a few different varieties.

Fixed vs. Variable Annuity

With a fixed annuity you receive a fixed monthly payment from your annuity. Your insurance company chooses your annuity investments and promises you a fixed-interest rate at which your annuity will grow.

On the other hand your payments will vary with a variable annuity based on the underlying investments. The rate of return on a variable annuity will vary based on the investments you’ve chosen. Your annuity’s value will depend on how your investments perform. The investment choices provided in variable annuities allow you to invest in sub accounts, which are similar to mutual fund accounts, but are held within the annuity.

Deferred vs. Immediate Annuity

You can decide whether you want to start receiving annuity payments immediately – an immediate annuity – or you can wait a few years to receive payments by choosing a deferred annuity.

You might choose an immediate annuity if you’re in retirement and you want to start receiving your annuity payments sooner rather than later. On other hand, if you’re not ready for retirement or you want to give your investment a chance to grow for a few years, you might choose a deferred annuity.

Tax Benefits of an Annuity

The money you contribute to an annuity has already been taxed, so you won’t pay any additional taxes on your contributions once you start receiving payments. Your earnings are tax-deferred and will be taxed when your payments begin. Gains are taxed as regular income, while annuitization is treated favorably, as it’s considered a return of premium.

There is no annual contribution limit for an annuity, so you can invest as much cash as you can afford and immediately defer it from tax. Unlike 401(k)s and IRAs, there are no tax breaks for contributing money to an annuity, though there are less restrictions.

Annuity Fees

You may find fees associated with your annuity account. This is especially true when it comes to variable annuities. Common variable annuity fees include administrative fees, mortality and expense risk charges, underlying sub account expenses, and charges for other features like special riders. You can compare multiple variable annuity product fees by reading each prospectus carefully.

If you decide to take money out of your annuity within the first few years of opening it, you may be subject to surrender charges. These often start at out around 7% and decrease each year until it zeroes out. This allows the advisor to get paid without charging an up front commission. There are variable annuity products available that are liquid, in that they have no surrender charges. These often come with higher operating expenses. Though these products come with higher costs they do have some advantages, Check with your advisor to see if they are right for your unique situation.

All annuity products do have withdrawal restrictions. You’ll be charged a 10% early withdrawal fee if you take money out of an annuity before you reach age 59 ½, so plan accordingly.

Receiving Annuity Payments

You can choose several options for how you receive your annuity payments.

You can opt for lifetime payments where you receive fixed or variable annuity payments during your lifetime. Your payments are based on your total investment and your life expectancy. With lifetime payments, you won’t have any survivor benefit, so your heirs won’t receive anything from your annuity at your time of death. The advantage to this is that you’ll receive maximum income that can never be outlived.

With a period certain annuity, you receive guaranteed payments over a certain period of time. You name a beneficiary who will continue receiving annuity payments if you pass away before the guaranteed period ends.

A life with period certain annuity allows you to receive guaranteed payments for a certain period of time and will continue to pay your beneficiary if you pass away within a certain period of time called the certain phase.

Finally, with a joint and survivor annuity, your beneficiary can receive payments for the rest of his or her life even after you die.

You can choose to withdraw the balance of your annuity, but be careful, if you make the withdrawal before you turn 59 ½ you’ll face a 10% early withdrawal penalty. You might also face a surrender charge if your annuity is still in its surrender period.