What Are Annuities?

Types of Annuities & How They Work

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An annuity is an insurance contract. Many people think of an annuity as an investment, but when you purchase an annuity, you are buying an insurance policy. You're ensuring an outcome.

You put money into the insurance contract, and the insurance company provides you with a guarantee as to when and how you will get that money back.

There are several types of annuity products, and each type works differently. This can lead to a lot of confusion. Annuities are categorized in two ways: according to when you start receiving an income (immediate and deferred annuities) and by how the annuity increases in value (fixed, indexed, and variable annuities). Here's a look at these annuity categories and how each type of annuity works.

Immediate Annuity

With an immediate annuity, you give the insurance company a lump sum of money. The insurance company pays you a guaranteed monthly income that starts within one year of when you took out the policy. It either pays the income out over a set time period, such as 10 years (called a term-certain annuity), or it pays you for as long as you live.

Think of an immediate annuity that pays out over your entire life as a jar of cookies. You give the insurance company your money (a full jar of cookies), and it hands you back a cookie each year. If the jar becomes empty, it promises to keep handing you cookies anyway, for as many years as you live. In return, you agree that once you hand in the jar, you can’t reach in and take a cookie anytime. If one year you want three cookies, you’ll have to get them from somewhere else—not from the insurance company's jar.

This unending supply of cookies means a life payout annuity is a good hedge against living a long time. No matter how long you live, and no matter how much of your other money you spend early in retirement, you’ll still get a cookie each year.

Deferred Annuity

With a deferred annuity, you deposit money today, and an income stream is guaranteed to start in the future. This type of annuity has an accumulation phase and a payout phase. During the accumulation phase, the annuity may increase in value. During the payout phase, you receive an income based on a schedule that you choose. It may be for life or for a specific time period.

A deferred annuity may also be called “longevity insurance” and there is a special type of deferred annuity, called a qualified longevity annuity contract (QLAC), that you can purchase with your 401(k) or IRA money. With a QLAC, the income usually starts at age 85, so you buy this type of annuity to ensure that you will have a minimum income level later in life.

Annuities offer tax-deferred growth. That means you don't pay taxes on investment gains until you take money out of the annuity.

Fixed Annuity

fixed annuity is a type of deferred annuity. You contract with an insurance company and it provides you with a guaranteed interest rate on your investment. A fixed annuity works a lot like a certificate of deposit (CD) issued by a bank. Instead of the bank guaranteeing your interest rate, the insurance company is providing the guarantee.

The interest rate is usually guaranteed for a fixed amount of time, such as five or 10 years. After that time period is over, the insurance company will tell you what your new interest rate will be.

A fixed annuity can be a smart choice if you want low-risk growth of your retirement funds. It might also be a good choice if you'll be in a lower tax rate when you withdraw the funds and you're willing to leave your funds in the contract for the required amount of time.

If you withdraw money from an annuity before age 59 1/2, you may have to pay an early withdrawal penalty of 10%.

Indexed Annuity

Indexed annuities are another type of deferred annuity. They are also called fixed indexed annuities (FIA) or equity-indexed annuities. With this type of annuity, the insurance company offers a minimum guaranteed return along with the potential for additional returns by using a formula that ties the increases in your account to a stock market index.

The minimum guarantee means that you can participate in the upsides of the stock market without experiencing the downsides. If the stock market index value goes down, you still earn a minimum amount instead of losing money.

Indexed annuities have complex features such as participation rates and cap rates that spell out how your returns are calculated. Insurance companies vary when it comes to how they calculate your returns, so compare potential indexed annuities carefully.

Variable Annuity

variable annuity is a deferred annuity contract with an insurance company in which you get to choose how the funds inside the contract are invested. The insurance company provides a list of funds (called subaccounts) to choose from. The list might include mutual funds, bond funds, and fixed accounts. It's called a variable annuity because the returns you earn will vary depending on the underlying investments you choose.

Contrast this with a fixed annuity, where the insurance company is contractually providing you with a guaranteed interest rate. With a variable annuity, you can lose money depending on the performance of your investments, but you may have a higher income potential than with a fixed or equity-indexed annuity.

Investments inside a variable annuity grow tax-deferred, so, just as within an IRA account, you can move money between investments without paying capital gains taxes.

For the variable annuity to qualify as an insurance contract, guarantees must be provided. The most common type of guarantee is a death benefit guarantee. A death benefit guarantee ensures that after you die, the greater of the current contract value or the full amount of your contributions (minus any withdrawals) will be paid out to your beneficiary. For example, if you invest $100,000, and the investments went down in value to $90,000, and you passed away at that time, the contract would pay $100,000 to your named beneficiary. If the investments had gone up in value and were worth $110,000, the contract would pay out $110,000.

Choosing an Annuity

What type of annuity should you choose? That depends on several factors. An experienced financial professional, like a financial planner or accountant, can help you decide whether an annuity is right for you. In general, annuities are best for long-term planning. This is because most annuities have surrender charges, so if you cash in an annuity early, you could pay a hefty fee.

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