An annuity exchanges present contributions for future income. Annuities are a common retirement planning tool for those looking to lower the risk of outliving their savings.
Simply put, annuities are contracts between you and a financial institution (usually an insurance company). You, as the annuitant, pay either a lump sum or monthly premiums, and in turn, the company promises to provide you with a future stream of income.
Annuities can be quite varied, as they are customizable based on the terms of the contract between the investor and the insurance company. There are several types of annuities, each with its own set of rules and benefits. The specific terms of the annuity contract dictate the type of annuity, the timing and amount of payments, the rate of return, and any additional features or benefits.
That said, here is a very basic overview of how annuities work:
You purchase the annuity contract through an insurance company or another financial institution with either one lump sum or a payment plan. You can purchase annuities from:
The insurance company invests money from your purchase in various ways. Depending on the type of annuity you purchase, you could actually see some return on that investment. A variable annuity would give you a larger payout if the markets do well. But, a fixed annuity carries less risk, as its payout does not depend on the markets.
Depending on the terms of your contract, annuities begin paying out on a future specified date. As the terms probably already imply, an immediate annuity pays immediately, and a deferred annuity pays much later on.
There are several different types of annuities to choose from. Let’s talk about a few of the most common.
An immediate annuity is a financial product that provides a fixed, reliable source of income, which can serve as a supplement to other retirement income. This type of annuity is funded by a single lump sum of money paid to an insurance company. Payouts from an immediate annuity can begin as early as one month after purchase, offering an ongoing, guaranteed stream of income for a specified period or even for life. An immediate annuity is often considered the most basic and original form of an annuity.
The appeal of immediate annuities lies in their simplicity and the security they offer. The purchaser exchanges a lump sum for a guaranteed income, effectively turning their savings into a retirement paycheck. This stream of income is not affected by market fluctuations, providing stability and predictability for the annuitant’s financial planning.
Deferred annuities are designed to provide payouts in the future. The key feature of a deferred annuity is its accumulation phase, during which the annuitant pays either a lump sum or monthly premiums to the insurance company. This money is then invested with the aim of growing the initial investment over time. The accumulation phase can last for several years, depending on the specific terms of the contract and the financial goals of the annuitant.
The money invested in a deferred annuity grows on a tax-deferred basis, meaning that taxes aren’t due on the earnings until they’re withdrawn. This allows the investment to grow more rapidly than it would in a taxable account. However, when withdrawals are made, typically during retirement, they are taxed as ordinary income.
A fixed annuity promises to pay a specific and guaranteed interest rate on account contributions. Fixed annuities are generally considered predictable and safe for retirement.
A variable annuity’s interest can fluctuate based on the performance of an investment portfolio. There is usually more risk involved as well as higher fees.