Annuities date back to ancient Rome, where they were used to guarantee an annual payment to citizens in exchange for a single payment made earlier on in life. This payment was meant to provide an income for elderly citizens when they could no longer work. Today, fixed annuities provide those same advantages.
The most basic type of fixed annuity is an immediate annuity. An immediate annuity is an annuity that guarantees you an income. This income payment can last for a set number of years or for your whole life. You get to choose how long the payments continue for. A deferred annuity acts like a long-term savings where you contribute money over time and it accumulates at interest until you elect to receive payments from the annuity.
The money in the annuity is invested in bonds, regardless of whether it is an immediate or deferred annuity. A bond is a loan made to a company or to a government. The company or government pays interest on the loan. This constitutes the interest that is paid to the annuity.
The benefits of a fixed annuity are that you are guaranteed to receive a set payment or interest rate. Fixed annuities are also not subject to taxation if the money is left inside the annuity. Once you receive payments, you are taxed. However, immediate annuities enjoy more favorable taxation because most of the payment sent to you is principal. A small portion of the payment is interest. This reduces your overall tax liability.
The disadvantage to fixed annuities is that the interest rate is low. This is because guaranteed rates must be sustainable over a long period of time. A high fixed rate is not possible. Annuity rates often mirror or are just slightly higher than bank CD rates. Additionally, if you choose not to convert your savings to an immediate annuity, then all withdrawals are treated as though you are withdrawing investment income first and principal last. This increases your tax liability.
Consider whether you want stability and are willing to trade the potential for higher investment returns. Fixed annuities are focused on the return of your money, with some growth over time. However, these contracts are very long-term contracts. Generally, significant growth happens over 10 or more years.
- "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
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