Basic Rules of an Annuity
In the United States, an annuity is a retirement investment plan you purchase from an insurance company. In exchange for your periodic or lump-sum deposits, the insurance company agrees to make regular income payments to you beginning immediately or at some future date. Annuities typically offer tax-deferred growth of earnings and may feature a death benefit that will pay your beneficiary a guaranteed minimum amount, such as your total deposits. Understanding the rules and features of an annuity can help you make the most of this retirement investment tool.
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Accumulation or Payout Phase
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An annuity typically features two phases. During the accumulation phase, you make periodic deposits that are allocated to various investment options. The gains generated inside the annuity are tax-deferred until you begin receiving payments. The payments begin during the payout phase, and you are taxed on the earnings at ordinary income tax rates rather than lower capital gains tax rates.
Fixed or Variable
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The investment component of the annuity typically comes in two types: fixed or variable. In a fixed annuity, the insurance company guarantees that you will earn a minimum rate of interest during the time that your investments are growing. The insurance company also guarantees that you will receive periodic payments guaranteed to equal a certain amount per dollar in your plan. In a variable annuity, you can choose where to invest your deposits from a number of available investment options, such as bond and equity mutual funds. The amount of periodic payment you eventually receive depends on the performance of the investments you choose.
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Payout Options
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At the beginning of the payout phase you may choose to receive your deposits and accumulated investment gains in a series of payments at regular intervals, generally monthly. Most annuity contracts offer you a choice of payment streams from a fixed period of no less than 20 years to an indefinite period such as the length of your lifetime or the lifetime of both you and your spouse. These latter options guarantee that neither you nor you and your spouse can outlive the retirement income paid from an annuity.
Death Benefit
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A common feature of an annuity is the death benefit. If you die, the person selected as your beneficiary may receive the greater of the accumulated value of your account and the total deposits made. Under some variable annuity contracts you also can "lock-in" any gains up to a certain period under a stepped-up approach.
Surrender Charges
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Annuities also may incur charges if you make withdrawals in the early years of the contract. These surrender charges are usually applied as a percentage of the amount withdrawn and gradually decline over a certain period of time. The typical annuity contract has surrender charges declining over an average period of seven years.
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References
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