An annuity is a contract that you have with an insurance provider that commits the insurer to paying you in the future or right away. Either a single payment or a series of payments are required to purchase an annuity. Like how your payout can occur in either a single lump sum or a series of installments over time.
Typically, people purchase annuities in order to control their retirement income. Annuities provide three things:
- Recurring payments over a predetermined period. You may have to live with this for the rest of your life, together with your spouse or another individual.
- Death benefits. If you pass away before you start collecting payments, the beneficiary you name will get a specific sum.
- Tax-deferred growth. You are exempt from paying taxes on the income and investment gains from your annuity up until the time you withdraw funds.
There are three basic types of annuities, fixed, variable and indexed. Here is how they work:
- Fixed annuity - Your insurance provider guarantees you a set quantity of recurring payments and a minimum interest rate. State insurance commissioners oversee fixed annuities. To find out more about the benefits and drawbacks of fixed annuities and to confirm that your insurance broker is qualified to provide insurance in your state.
- Variable annuity - Your annuity payments can be directed by the insurance company to a variety of investments, typically mutual funds. Depending on your investment amount, investment yield, and outgoing expenses, your payout will change.
- Indexed annuity - The benefits of both securities and insurance products are combined in this annuity. A return estimated using a stock market index, such as the Standard & Poor's 500 Index, is credited to you by the insurance provider. State insurance commissioners oversee index annuities.
- Income flow guarantees, sometimes for life
- Customizable options of return.
- May offer specific creditor and probate protections
- Illiquid with fees and penalties for withdrawals
- Could have significant sales commissions or fees
- Likely to generate unforeseen taxable events
- May be complicated to understand
- Annuities are insurance contracts that guarantee you'll receive a consistent income either now or in the future.
- In contrast to an immediate annuity, which turns a lump amount into cash flows right away, a deferred annuity has an accumulation period followed by a payout (annuitization) phase.
- You can purchase an annuity using a single payment or a series of installments made over time.
- Fixed, variable, and indexed annuities are the three most common varieties. Each has a different level of risk and possible payout.
- Unlike long-term capital gains, which are often taxed at lower rates, annuity income is typically subject to standard income tax rates.