How Does an Annuity Work?
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Introduction
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Investing in an annuity is one way to save for retirement or to save for a child’s college fund. A key benefit to investing in annuities is the tax-deferred status your money holds during the investment period. You can also use annuities -- for a price -- to insure your investments against catastrophic loss. There are many different types of annuities and payout options. The key point to remember when you invest in an annuity is that nothing comes for free -- if you are protected against a stock market collapse or you are guaranteed certain payouts regardless of how long you live, you will pay for those protections.
Definition
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In technical terms, an annuity is a contract or agreement with an insurance company in which, in one way or another, you pay a premium in exchange for receiving a guaranteed payment from an investment. The premiums can take many forms, as can the payouts -- you can find annuities that will pay a certain amount per month after you reach a certain age until death; annuities that include a death benefit along with regular payouts; annuities that pay out fixed amounts based on the initial contract; and annuities that pay variable amounts, depending on the performance of investment accounts. The payments can be made in a lump-sum amount, or in portions over a period of time. Typically, tax free withdrawals cannot be made until the age of 59 1/2. If a withdrawal is made prior to this age, tax penalties and surrender charges will likely be applied. Basically, it is important to remember that an annuity is never just a simple investment account -- the payouts are always, in some way, related to the premiums you pay to secure them.
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Features
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Unless your annuity is structured as part of a qualified retirement plan, the money you invest is taxed at the time you put it in. Consequently, you may be hit with penalties for early withdrawal on your investments, but you will only be charged regular income tax rates on the investment’s earnings. The surrender charge is applied by the insurance company that held the investment. These same penalties do apply when an annuity is being used to fund a child’s college education.
Annuity payouts are taxed depending on what type of annuity you have.
-- Qualified annuities are funded with before-tax dollars. No taxes are applied to after-tax portions invested in the plan when it comes time for withdrawal, and investment earnings are not taxed until withdrawal.
-- Non-qualified annuities are funded with after-tax dollars. Taxes are applied to the earnings portion of your investment at the time you withdraw your money.
Types
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The types of annuity options available vary according to how your money is paid in, how it is withdrawn and how the money is invested. Among the major types of annuities:
-- Single premium annuities: You invest one lump-sum amount in exchange for guaranteed payouts later on.
-- Flexible premium annuities: These allow for a minimal investment, with varied payment amounts throughout the investment period.
-- Fixed annuities: These are placed in more conservative investment vehicles like bonds. Your principal investment amount is typically guaranteed, and a minimum earnings interest rate is guaranteed as well throughout the contract's term.
-- Variable annuities: These are typically invested in mutual funds. The principal investment amount is not guaranteed, and payouts are determined by how much your investment earns. Depending on the contract you buy, the insurance company might agree to guarantee some level of investment value for you so your losses will be limited if the markets collapse.
Benefits
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You, as the investor, have the option to choose how your withdrawals, or payout amounts, will be made. The varieties of payout options are virtually endless. Fixed-amount payouts are made until the annuity is used up. Fixed-period payouts are made over a predetermined period of time. Lifetime payouts are made until you die, and in some cases will continue until your spouse dies as well. The installment-refund option makes payments available to your survivors should you die before the annuity is used up.
It’s best to research annuity options before you make an initial investment. Your individual needs and circumstances can help determine which annuity option is best for you.
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