What is an annuity?
How do annuities work?
How do annuities differ from life insurance?
What Is An Annuity?
An annuity is a contract between an individual (“annuitant”) and an insurance company. The annuitant agrees to pay the insurance company a single payment or a series of payments, and the insurance company agrees to pay the annuitant an income, starting immediately or at a later date, for a specified time period. Under current tax law, money put into an annuity grows on a tax-deferred basis until the annuitant begins receiving his accumulated fund as an income. That means that one hundred percent of your earnings are reinvested in an annuity and allowed to compound — or grow — without having to pay taxes on earnings.
Here are some of the features of an annuity you will want to consider before investing:
- Tax-Deferred Growth
- Lifetime Income
- Liquidity In Case Of Emergencies
- No Limit On Contributions
- Death Benefit
- No Load or Fees
- Bonus Rates
- The Strength of the Insurance Company
- The Rate Of Return
- Professional Investment Management
- Investment Choices
- Fixed vs. Variable Rates of Return
- Surrender Charges
Tax-Deferred Growth. Money invested in an annuity grows on a tax-deferred basis. Your investment profits are taxed only when you begin to receive an income from your annuity. All other things being equal, your money will grow faster in a tax-deferred annuity than in a taxed investment, such as a CD or mutual fund — thanks to the magic of compounding.
Lifetime Income. An annuity can provide you with a guaranteed lifetime income, regardless of how long you live. No other investment instrument can provide this guarantee.
Guarantee of Principal. Some variable annuities guarantee to return at least your “”principal” — e.g.,., the total payments you’ve made, at the time you begin receiving your annuity income. This can be an important feature for people who want some upside potential while minimizing risk.
Liquidity In Case Of Emergencies. If you suffer a serious illness (e.g., heart attack, cancer, etc.) some products may allow you to withdraw up to 25% of your accumulated fund early without paying a surrender penalty. If you are diagnosed as likely to die within 12 months, you may be allowed to withdraw your entire fund subject to certain limits.
No Limit On Contributions. Unlike other tax-advantaged investments, such as IRAs, you can contribute an unlimited amount of money to an annuity during the year, whether in periodic installments or a lump sum. Individual carriers may place a ceiling on the total amount you may put into an annuity without approval.
Death Benefit. If you die before you begin receiving an income, your beneficiaries could receive a death benefit equal to the amount of money you’ve paid into your annuity or its current investment value (which could be less than the amount paid in for some types of annuities).
No Load or Fees. Annuities are generally no-load, no-fee investments, which means more of your money is actually invested than with investments where some money is used to pay an initial or annual charge.
Bonus Rates. Some annuities award investors with bonuses — extra interest that further increases your investment — at the end of your annuity’s first year . The bonus increases the annuity’s principal on which future interest will be calculated in subsequent years, thus providing a substantial boost to the ultimate value of an annuity fund.
The Strength of the Insurance Company. Since an annuity is backed only by the issuing insurance company for many types of products, it is wise to make certain you’re dealing with a reputable, well-known institution before you invest. A company’s A.M. Best rating is a good measure of a company’s financial strength and stability.
The Rate Of Return. Like any investment, annuities offer differing rates of return, some higher than others. Check an annuity’s rate of return before you invest in it.
Professional Investment Management. Since your annuity is generally managed by the insurance company’s professional money managers, it’s a good idea to scrutinize the company’s investment record and credit rating history before investing with them.
Investment Choices. Annuity funds can be invested in a variety of different financial instruments, such as money markets, government securities, mutual funds and stock. Some annuities let you decide how your money will be invested within a range of choices established by the insurance company.
Fixed vs. Variable Rates of Return. Fixed-rate annuities offer a guaranteed rate of return, while a variable annuity’s rate of return will vary with the rate of return of the underlying investments Variable-rate annuities offer greater risk and the potential of a higher return than fixed-rate annuities. (That said, most fixed-rate annuities offer some rate variability and variable-rate annuities may offer a low minimum guaranteed rate as a hedge against potential losses.)
Surrender Charges. You may have to pay the insurance company a “surrender charge” if you withdraw more than the allowed amount in any year (generally, 10% of the fund’s value) during the surrender charge period which is usually seven to ten years from the annuity contract date.
How Do Annuities Work?
It’s a simple contract: You agree to make a single or a series of payments to an insurance company which the company invests. In exchange, the company promises to pay you an income starting on a specific date. Most people begin receiving annuity income when they retire and continue receiving it for the rest of their life.
The money you invest in an annuity grows on a tax-deferred basis. Your annuity income is taxed as normal income when you begin receiving it (though no income tax is paid on that portion of the income that represents the money you originally paid in to your annuity). Since most people receive annuity income after they retire when they may be in a lower tax bracket, they generally pay less tax on annuity income than on income they earn while working full time.
How Do Annuities Differ From Life Insurance?
Life insurance pays your family cash benefits when you die. Annuities typically begin paying you an income when you retire and may continue paying you an income for as long as you live. (Most annuities stop paying money when you die; though some annuities can continue paying money to your family after your death if you select that option.)