What Is An Annuity And How Does It Work?

An annuity is a life insurance product. It is a form of insurance or investment entitling the investor to a series of annual sums. It’s a savings account with a life insurance company.

An annuity is actually a contract between you and an insurance company. You, the annuitant, will pay for the annuity through a lump sum or payments made over time.

The insurance company makes money by investing your money. The most common way an insurance company invests is through mutual funds.

If someone works for a company that doesn’t have a pension annuities are the best and cleanest way to create one.

From these earnings, the insurance company will make regular payments to you. Again these are in the form of a lump sum or payments over time. There are several types of annuities and the exact payment structure of each will vary based on the terms and requirements that the annuitant agrees to with the insurance company.

There are four categories of annuities with life insurance companies.

Fixed Annuity, Immediate Payment Annuity, Indexed Annuity, and an Individual Retirement Annuity.

To simplify it, there are 2 types of annuities, fixed and variable.

Fixed annuities pay you a cd (certificate of deposit) rate or slightly higher, around 2 or 3% in 2020. You take a fixed amount of dollars today and receive a fixed income stream for that money.

A second kind of fixed annuity is a deferred fixed annuity. This is where you take that sum of money and put it to work in the annuity to earn a guaranteed stated rate of return over a defined period.

It’s not creating income in the annuitant’s hands yet, but is a growth mechanism of a fixed rate over a fixed period. The money grows inside the annuity tax deferred like a 401k or IRA does.

There is a surrender charge and usually has a 7 year seasoning before that surrender charge ends.

A variable annuity is an investment vehicle that has mutual funds inside, and they have extra benefits after you’ve maxed out your retirement accounts. The payments you receive will depend on how well your investments perform.

An indexed annuity is technically a version of a fixed annuity, it mostly combines the benefits of both fixed and variable products. The returns you earn from an indexed annuity aren’t based on investment decisions of the annuitant. Instead, the money will follow the performance of a stock market index like the S&P 500.

Annuitization is what’s known as converting an annuity investment into periodic payments paid out to the annuitant. Annuities may be annuitized for a specific period of time, or for the life of the annuitant.

Video: What Is An Annuity And How Does It Work?

At What Age Can You Annuitize?

You can avoid the 10% penalty by withdrawing substantially equal annual amounts over your life expectancy until age 59 ½ or for five years, whichever comes later. So, if you are age 58, you must take withdrawals through age 63. But, if you are age 45, you need to continue making withdrawals through age 59 ½.

Can You Lose Your Money In An Annuity?

The value of your annuity changes based on the performance of those investments. … This means that it is possible to lose money, including your principal with a variable annuity if the investments in your account don’t perform well. Variable annuities also tend to have higher fees, increasing the chances of losing money.

What Is The Safest Type Of Annuity?

One of the most frequently asked questions from investors is “are annuities safe?” The answer is yes, they are very safe. Fixed annuities are one of the safest investment vehicles available today.

Is An Annuity Better Than a 401k?

Another big difference is that an annuity offers a guaranteed payment for as long as you live. That means, at least with most annuities, you can’t run out of money. A 401(k), on the other hand, can only give you as much money as you have deposited into it, plus the investment earnings on that money.

A quick tip: There is usually no need to house your annuity inside a 401k because the annuity already has tax benefits. Housing an annuity inside a 401k would double down on tax advantages. The annuitant can only use the tax deference once.

What Are the Pros of Annuities?

  • Your Contributions Can Grow Tax-Deferred
  • You Will Receive Regular Payments
  • Death Benefits Are Typically Available Making It Essentially Willable
  • Fixed Annuities Offer Guaranteed Rates of Return

What Are the Cons of Annuities?

  • Annuities Can Be Pricey
  • Getting Out of an Annuity May Be Difficult or Impossible
  • Returns of an Annuity Might Not Match Investment Returns For Annuity Fees And Gains Can Be Capped Through Something Called a “participation rate.”
  • Inflation Can Be Greater Than The Rate Of Return In Some Years In Rare Cases

Guiding Cents Staff

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