Annuities are often touted as an investment, but they actually work more like an insurance policy. When you buy an annuity, you pay a company a set amount of money and are guaranteed to get a lump sum of cash every month for the rest of your life.
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Types of annuities
A fixed annuity sets a guaranteed payout for the rest of the beneficiary’s life. Fixed annuities can provide predictability and a steady income during retirement.
A variable annuity’s payout stream is determined by the performance of an underlying investment. Variable annuities provide growth potential.
A combination of a fixed and a variable annuity is known as an indexed annuity. The annuitant receives a guaranteed minimum payout while the rest of the payment varies along with the underlying investment’s performance.
Immediate annuities begin to pay a short period after the investment is made. These can be fixed or variable.
Any money earned by investing in a deferred annuity will be accumulated until the payout is set to begin. Deferred annuities can be fixed or variable and can be converted to immediate annuities once the payout is desired.
How to choose an annuity
Annuities have a reputation for becoming accompanied by hefty fees. While certain costs are to be expected, consumers should clearly understand them before purchase.
- Surrender fees: Be sure to understand the surrender fee that will be paid if the money is taken out of the annuity before the contract time period is up.
- Commissions: Similar to investment products, annuities are bought and sold on the market, and an advisor or agent makes a commission from the sale. This charge is paid by the consumer.
- Monthly fees: Annuity monies are invested, often in mutual funds. These funds usually incur fund management fees, and the costs are passed on to the consumer.
The initial funds used to purchase an annuity can come from many sources. There are also ways to add to an annuity once it has been created.
- Single payment: The simplest option for consumers who have a lump sum of money and want to put it into an annuity is to write a check or wire the money to the company.
- Series of payments: Some annuities allow consumers to initially fund the account with a small amount of money and then add to the principle periodically. This is a form of saving while growing money for retirement.
- Social Security: Consumers can choose to reduce their Social Security benefits in the near term and use the savings for an annuity for the long term. Consumers should carefully consult a financial advisor regarding this option.
Annuity funds are invested in various markets. Depending on the type of annuity, consumers can have more or less control over the underlying investment options.
- Immediate annuities: An immediate annuity offers, as the name implies, immediate results. You make a lump sum payment and immediately (or almost immediately) begin to get a guaranteed monthly payment. Immediate annuities generally are paid out for the rest of your life, but they can also be paid out over another set period of time that you specify.
- Fixed annuities: When you buy a fixed annuity, your rate is locked in for a guaranteed amount of time ranging from one to ten years. Your rate might still fluctuate, but it will never go below the amount you set with your fixed annuity. This type of annuity is good for people who want a low-risk insurance plan and aren’t concerned about growing their annuity.
When purchasing an annuity, the consumer can choose how the future payments will be made.
- Guaranteed period: This option provides a guaranteed number of payments. Upon death, the payments continue to a beneficiary for a set period of time.
- Lifetime payments: The guaranteed payment, in this case, is for the lifetime of the annuity holder only. This option provides no survivor benefits. Lifetime payments may be appropriate for those with no beneficiaries.
- Survivor payments: Popular with married couples, this type of payment will continue for the life of the holder and, upon death, will then continue for the life of the beneficiary as well.
There are several ways to withdraw money from an annuity. However, there are also many fees and penalties associated if the money is withdrawn before the age of 59 1/2. Consumers should be sure they clearly understand all the tax and other financial implications of withdrawals.
- Annuitization: This option converts the current value of the annuity into a stream of payments. It provides a guarantee of steady income for the life of the annuitant or can provide a steady income to beneficiaries after the death of the annuitant, based on a chosen time period. Payments can be made using a fixed amount or a variable amount.
- Systematic withdrawal: With this option, the consumer chooses how much and when payments will be made. This can include withdrawing only the earnings or withdrawing the principal and the earnings. However, there is no guarantee of payments for life when making withdrawals.
- Lump sum: It’s possible to take the entire lump sum of an annuity’s value; however, the investment gain will be taxed as ordinary income. If a withdrawal is made before age 59 1/2, penalties will also be due.
Who should invest in annuities?
Annuities are an option for consumers who want to let their money grow and at the same time avert taxes on income. These consumers are usually confident that they will not need to access their money for a long period of time and reasonably expect to outlive their savings.
Savers plus income generators
This group of consumers wants both the ability to grow income and still have access to assets. They often include people nearing retirement age.
For those who are now living from their savings, an annuity can create a predictable and guaranteed stream of income for life. People often use this income to cover essential retirement living expenses.
Social Security recipients
Individuals who have a Social Security or pension plan income may want to use an annuity to supplement these sources.