An annuity is an insurance policy that guarantees you an income for life or for a set number of years when you retire. The annuity you buy from an insurance company may offer a variety of features. But, there are some features and benefits that are common for all types of annuities. Make sure you understand the basics of annuities before you invest in one.
There are a few basic types of annuities. First, annuities are divided by either "immediate" or "deferred." An immediate annuity is an annuity that converts your savings to monthly payments. You may elect monthly payments for life or for a set number of years. A deferred annuity is an annuity that defers this guaranteed payment. Instead, the annuity acts like a long-term savings. The annuity's value increases over time and may be converted or kept as a savings.
Finally, annuities are divided by "fixed" and "variable" contracts. A fixed annuity earned a fixed rate of return on your investment principal. A variable annuity earns a variable rate of return on your investment principal that is tied to mutual fund investments.
The main feature of an annuity is that it provides a guaranteed income and flexible withdrawal strategies. With a deferred annuity, the withdrawals may be made on a systematic or periodic basis. A systematic withdrawal is a withdrawal made on a regular basis and is normally used as withdrawals for income. A periodic withdrawal is a withdrawal designed to be used for "emergency withdrawals." An immediate annuity provides for guaranteed income over your lifetime or for a fixed number of years. Lifetime income stops when you die. Income payments that last for a set number of years are called "temporary annuity" or "period certain" annuity payments.
The benefit of annuities is that they ensure that you have the option to secure your retirement income and never run out of money, regardless of how long you live. Regardless of whether you invest in a variable or fixed annuity, the annuity contract provides income insurance at retirement. You don't have to convert the annuity to payments, but you always have the option to do so.
The disadvantage to annuities is that these are long-term investment products. For deferred annuities, you must normally hold the policy until you retire. Otherwise, there are IRS penalties, and sometimes penalties from insurance companies, that will reduce your savings for early withdrawals. In addition to this, a deferred annuity converted to immediate annuity payments may not adjust for inflation. So, while you receive a guaranteed income, the value of that income is never guaranteed unless your insurance company offers an inflation adjustment.
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- "Life Insurance"; Kenneth Black, Jr., Harold D. Skipper, Jr.; 1994
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- IRS: Publication 575 -- Pension and Annuity Income
I am a Registered Financial Consultant with 6 years experience in the financial services industry. I am trained in the financial planning process, with an emphasis in life insurance and annuity contracts. I have written for Demand Studios since 2009.