What Is an Annuity?

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Annuity

A contract between you and an insurance company known as an annuity entails you making a lump sum payment or a series of payments in exchange for regular payments starting either right away or in the future.

Understanding Annuities

The goal of any annuity is to have a steady income, usually during retirement. Like 401(k) contributions, money accrues tax-deferred and can only be withdrawn without penalty until age 59(1/2).

An annuity can be customized in many ways to meet the individual needs of the buyer. You can decide when you wish to annuitize your contributions, that is, begin receiving payments, in addition to deciding whether to make a single payment to the insurer or a series of installments. An immediate annuity is one that starts making payments right now, while a delayed annuity starts making payments at a specific future date.

The duration of payment may also vary. You can choose to receive payments for a fixed period of time, such as 25 years, or for the rest of your life. Of course, guaranteeing lifetime payments can reduce each check, but it helps ensure that you don’t outlive your assets, which is one of the main selling points of annuities.

Types of Annuities

Annuities come in three main types: fixed, variable, and indexed. Each type has its own level of risk and ability to pay. For each of them, it is organized as a pension fund.

Fixed

A fixed annuity pays a guaranteed amount. This type of annuity comes in two different forms: immediate annuity, which pays you the amount you pay now, and annuity, which pays you. later on. The downside of this policy is the low annual return, often higher than a certificate of deposit (CD) from a bank.

Variable

Variable annuities offer higher potential returns and higher risk. In this case, you choose from a collection of funds that go into your personal “sub-account”. Here, your pension depends on the performance of your investments in your micro account.

Indexed

Indexed annuities fall somewhere in the middle when it comes to risk and potential rewards. You receive a guaranteed minimum payout, although part of your return is linked to the performance of a market index, such as the S&P 500.

Despite their potential for high returns, mutual funds and indexed funds are often criticized for their complexity and fees. Many annuities, for example, will pay a higher redemption fee if they withdraw their money within the first year of the contract.

Important: Variable and index annuities are often criticized for their complexity and high fees compared to other types of investments.

Tax Treatment of Annuities

One important thing to consider in any year is its tax treatment. Although the balance grows tax-free, your income is subject to income tax2. Your income is taxed on your income tax return. In contrast, the income you have held for more than a year is taxed at the long-term capital gains rate, which is usually lower.

Plus, unlike a traditional 401(k) account, the amount you contribute each year doesn’t reduce the amount you’ll pay. For this reason, experts often recommend that you consider buying an annuity after you have contributed the most to your pre-tax retirement account for the year.

Annuity Pros & Cons

Pros
  • Fixed income, sometimes for life
  • It can be customized
  • Can provide some probate protection to the borrower
    Cons
    • Illiquid has penalties and withdrawal fees
    • May come with a great deal or reward
    • Can create a taxable program
    • Can be confusing to understand

    Are annuities good money?

    Annuities are designed as income-generating products and are not generally intended for financial appreciation. Therefore, annuities are best for those who want to invest their retirement money later or want to convert a large sum of money into guaranteed money over time.

    Who should not buy an annuity?

    Investors or investors looking for financial benefits will not be able to benefit from having an annuity, because it is intended to turn today’s dollar money into future money. Those who need money today should also avoid annuities because the money invested in them often has restrictions and penalties.

    Can You Lose Money In an Annuity?

    If you die before all the annuities from each year are paid, you may receive less than what was originally invested. Survivorship annuities that provide beneficiaries will avoid this problem. Note that you can also lose out on inflation if you don’t pay special annuities to CPI or a similar measure of the cost of living.

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