What is an annuity?
An annuity is a special contract issued by an insurance company. While it is not an insurance policy, there are similar characteristics between an insurance policy and an annuity. Annuities can be a critical piece of your retirement plan, and while they are not right for everyone, they can help you achieve your goals for retirement income.
There are two main types of annuities … fixed and variable:
- Fixed Annuities:
These types of annuities have a set rate of payout that remains constant throughout the distribution phase. Immediate annuities provide an income stream immediately after the contract is issued, whereas the income stream from deferred income annuities is delayed for a certain period of time, as specified in the annuity contract. - Variable Annuities:
The return on the investment in a variable annuity is based on the performance of underlying investments.
How does an annuity work?
There are two phases of an annuity contract: the accumulation phase, and the distribution phase.
- The Accumulation Phase:
The contract holder makes a single payment or series of payments to purchase an annuity contract with either a fixed or a variable rate of return. During this phase, the growth on the investment is tax-deferred. - The Distribution Phase:
In this phase, the annuity contract’s accumulated value can be converted into a guaranteed source of income that lasts a lifetime or a specific period of time. Earnings are taxed as ordinary income at the time of distribution.
Annuities can help provide assurance that you will have a steady income stream when you need it.
What are the main advantages and disadvantages of annuities?
- Primary Advantage:
Planning for retirement can be a bit challenging. Annuities can help provide assurance that you will have a steady income stream when you need it. Purchasing an annuity puts you in the driver’s seat; you choose when the time is right for taking the income … and how … you will take that income! - Primary Drawbacks:
An annuity contract is a long-term investment, and commits your funds to the annuity contract during the accumulation phase. In some cases, those funds are not available for withdrawal. In addition, there is some risk with variable annuities if the value of the underlying investments falls.
Annuities are products of the insurance industry. Guarantees are subject to the claims-paying ability of the insurance company and surrender charges may apply if money is withdrawn before the end of the contract. All withdrawals of tax-deferred earnings are subject to current income tax, and, if made prior to age 59½ may also be subject to a 10% federal income tax penalty. Annuities are designed for long-term retirement investing. The contract, when redeemed, may be worth more or less than the total amount invested.