What Is an Annuity?

Annuities are another tool in the retirement toolbelt. See how this particular type of plan works.

If you are planning your retirement and want to save more than the maximum amount you’re allowed to invest in an individual retirement account (IRA) or other retirement plan, you might need a little extra firepower.

What Is an Annuity?Specifically, you might want to consider adding an annuity to your retirement strategy.

What Is an Annuity?

Think of an annuity like a cross between an investment account and a life insurance policy (and in fact, they’re typically sold by life insurance companies).

When you purchase an annuity, you agree to invest a specific amount of money over time or in a lump sum. That money grows tax-deferred until a specific date — often when you retire — and the annuity payout period begins.

You can withdraw the money as a lump sum, but many retirees choose to take withdrawals at regular intervals, such as monthly or quarterly. Often, the payments are guaranteed to last the rest of your life, no matter how long you live.

How Does an Annuity Work?

Within the annuity, the investment account can hold money markets, mutual funds, stocks and government bonds. You can invest as much as you want, and while contributions can’t be deducted from your taxes, taxes are deferred while the annuity grows.

Figuring out the likely returns on your investment portion is extremely complicated and depends on the kind of annuity you buy, the guarantees offered and what portion is invested in stocks. Current annuity rates sit around 3%, but some companies offer bonus yields during the first few years. If you buy a so-called equity indexed annuity, you could earn more.

You must be 59½ or older to receive payments from the annuity. If you withdraw funds before then, you will face a penalty. A contract can be purchased as an individual annuity or a joint annuity. While some plans stop payment completely when the annuity owner dies, other plans allow for a beneficiary to be named when establishing the annuity contract. If a beneficiary is in place, the annuity does not have to go through probate when the contract holder dies.

What are the payment options?

  • Single Life: Payments are made over a time period that’s based on an estimate of your life expectancy.
  • Single Life With Guaranteed Term: Payments are made over a time period that you determine, say 10 or 20 years, but if you live longer than that period, you still can receive some payout from the annuity.
  • Single Life With Refund of Principal: Payments are made until death; if your original investment has not been paid at the time of your death, the company will pay out the rest to your beneficiary.
  • Term Certain: Like single life with guaranteed term, but you will not receive payments after the term has ended.

What about taxes?

The money placed in an annuity is tax-deferred until it is withdrawn as long as the person obtaining the distribution is 59½ or older. If it is taken out before then, a 10% penalty occurs (with some exceptions). The investment gain on withdrawals are usually taxed as ordinary income, though there are a number of other rules pertaining to taxes you’ll want to know about.

What about the fine print?

If you are considering an annuity, review the contract and make sure you understand the terms and any guarantees. Annuities often have high fees and expenses, and financial advisors typically also get commission on any sales. Since the annuity isn’t backed by the Federal Deposit Insurance Corporation (FDIC), make sure the insurance company selling the annuity has a strong track record.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/01/annuity/.

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