How Do Annuities Work?

Save

For people approaching retirement, or who just want a dependable stream of income, annuities provide an interesting option. The annuity is an investment contract that returns regular payments to the holder, who makes an initial lump-sum payment into the account. The length and payout of annuities may vary, and the buyer can choose from many types of annuities: deferred or immediate, for example, and fixed or variable.

(Image: Getty Images)

Why Annuities?

Holding a large amount of money for investment and assuring that those funds will allow a comfortable future can be daunting to those who have little or no experience as investors. Insurance companies have come up with the annuity, which guarantees a stream of payments to be made monthly, quarterly or annually over the life of the contract. The annuity company handles investment of the money, while the buyer of the contract gives up direct control over those funds and simply collects regular payments over the stated term.

Fixed and Variable

A crucial decision when shopping for an annuity is whether to get one that is fixed or variable. A fixed annuity assures the buyer that the payments will remain the same over the life of the annuity, which could be set for 10, 20 or 30 years. If the insurance company experiences investment losses, it's legally bound to make the fixed payments. A variable annuity pays more or less depending on the company's investment results. The buyer can select underlying investments that will render the returns more or less volatile. An annuity invested in stocks, for example, is prone to wider swings in payout than one invested in U.S. government bonds or money market securities.

Deferred Investment and Taxes

When a buyer gets into an annuity contract, he can either begin taking immediate payments or defer the income. A deferred payout that begins after the buyer reaches retirement has time to grow with investment returns; in addition, a retiree usually finds himself in a lower tax bracket than the one that applied while he was working. While the money remains in the annuity -- the accumulation phase -- there's no tax on the income and capital gains earned by the investments. When the distribution phase begins, taxes kick in on the rise in the annuity's value. Insurance companies also may guarantee a full return of the initial investment to beneficiaries if the buyer dies before the contract pays out.

Related Expenses

The downsides for annuity buyers include the high expenses that annuity companies typically charge. The expenses reduce the investment return over the life of the contract, or they raise the cost of the annuity at the outset, as do any sales charges. In addition, there may be management fees and a painful surrender charge if the buyer chooses to cash out of the annuity early.

Promoted By Zergnet

Comments

You May Also Like

  • How Much Does an Annuity Pay?

    An annuity is a sum of money that a financial company agrees to provide you in payments over time. This is usually...

  • Do Annuities Have Beneficiaries?

    With an annuity, the policyholder can invest a certain amount of money during his working life. The invested amount grows in the...

  • What Is Commission on Annuities?

    If you are an insurance agent and are considering selling annuities as a way to earn additional income, it's important that you...

  • How Does a Quadra Annuity Work in a Divorce?

    A Qualified Domestic Relations Order is a specialized court order created and enforced in divorces, where retirement assets such as 403(b) and...

  • How Do Insurance Companies Benefit From Annuities?

    Insurance companies benefit from annuities in a number of different ways. Learn about how insurance companies benefit from annuities with help from...

  • How Do Annuities Work?

    Annuities are essentially contracts that have two phases, a building phase and a phase in which a person gets their money back....

  • How Does an Annuity Work?

    Annuities work through accumulation and distribution periods. Discover the phases of annuities with tips from a registered financial consultant in this free...

Related Searches

M
Is DIY in your DNA? Become part of our maker community.
Submit Your Work!