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What is an Annuity?

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Definition

An annuity is a retirement product that pays out a steady stream of income or a lump-sum payment to you on a future date. Annuities are recommended for investors looking to improve their retirement strategy.

How it Works

In a nutshell, here’s how it works: you invest in an annuity, and it then gives payments either regularly or in one lump amount. Your investment grows tax-deferred over time, and this fixed or variable income can be received monthly, quarterly or annually.

An annuity has two phases and these are the accumulation and payout phases. During the accumulation phase, that’s the time wherein you pay your premiums or let your annuity mature and generate income. Meanwhile, the payout phase is the time when you will start receiving payouts from your annuity.

Receiving Payments

You can choose to receive payments for a number of years or for as long as you live. You can also choose to receive guaranteed fixed amounts or payouts that vary according to how well your annuity’s underlying investments perform.

How much you receive during the payout period is dependent on several factors such as your chosen payment period and the type of annuity contract you have.

Annuity Structure

Basically, these are the parties involved in an annuity:

  • Owner

As its name suggests, this is the person who owns the annuity. Meaning, he or she is responsible for paying the premiums, going through the application process, and paying taxes on withdrawals during the accumulation phase. He or she has the right to make withdrawals and choose an annuitant and beneficiary.

  • Annuitant

An annuitant is the person whose life expectancy is the basis of the annuity payment calculations. In most cases, the owner is also the annuitant.

  • Beneficiary

The beneficiary is the person who will receive the remaining value in your annuity once you’re gone. If you die before the payout date, your beneficiary will receive the full value of your annuity. Otherwise, he or she will only get any remaining amount left in the contract. Beneficiaries can receive payouts either in a lump-sum amount or periodic payments.

Meanwhile, a spouse who is named as the beneficiary has the option to assume ownership of the contract. If the annuity is qualified, he or she can roll it over to retirement accounts such as 401(k), 403(b), and IRA.

Minors are not allowed to be beneficiaries. If you want to name your child as a beneficiary, you should also appoint an adult custodian to administer the proceeds of the annuity to your child. Some states require your selected custodian to be approved by the courts.

  • Issuer

The issuer is the insurance company or financial institution that issues the annuity contract. They are responsible for enacting the guarantees written in the fine print and providing payouts on the designated dates.

The difference between Annuities and other IRAs

Annuities are similar to other retirement plans such as IRAs in that you can invest as little or as much as you can, and this capital compounds tax-free until you withdraw funds. The main difference is that there’s no cap or limit on how much you can invest in an annuity, making them great for those who have maximized their other retirement plans.

Different types of Annuities

There are numerous types of annuities available in the market today, but these are the main categories that they fall under.

  • Immediate vs. Deferred

Immediate annuities, as the name implies, will begin paying out after you settle your single premium or anytime between the next 12 months. Meanwhile, with deferred annuities, you have the option to settle premiums either through a lump-sum payment or periodic payments. Payouts from this type of annuity usually begin at a specific date in the future.

  • Fixed vs. Variable

These two types basically differ on how much payout you will receive. In a fixed annuity, your income will grow based on guaranteed interest rates.  On the other hand,  a variable annuity allows you to select investments where your money will be put in. Your payout will be based on how these investments performed.

  • With or Without Withdrawal Penalties

Generally, annuities impose a withdrawal fee if you decide to take out money from it prior to the set payout date. However, most annuities allow withdrawals by up to 10 percent each year. Should you exceed that rate, you need to pay a penalty. Meanwhile, some annuities have no withdrawal penalties, but they may come with higher fees.

You can learn more about each type here.

How to Choose the Right type of Annuity

There are numerous annuity products offered today, but each one essentially boils down to making these three choices:

  • Would you like to begin receiving payments now or later?
  • Do you want to receive fixed or variable payments?
  • Would you like to be able to make early withdrawals?

To be certain whether an annuity is the right investment for you, you’ll need to fully understand how it works and whether it fits your current retirement strategy.

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