How Does an Annuity Work

An annuity is basically an insurance product that allows a person to invest money, watch it grow tax deferred, and earn a regular income from the investment in the future or take a lump sum.

According to a CNNMoney report, annuities are popular with people who would like to receive a steady stream of income in retirement. Unlike an IRA, annuities do not have income limitation. This means you can put in as much money as you want into an annuity of your choice.

Annuities: So How Does an Annuity Work

A report published by Reuters reckons that annuities offer the best investment protection against longevity risk due to various reasons. To start with, this type of investment allows one to enjoy tax deferred growth of earnings, according to the US Securities and Exchange Commission. Secondly, an annuity contract allows the inclusion of a beneficiary who would receive a specified amount of money in the event the person who owns the annuity dies before retiring. Thirdly, annuities have attractive payout rates that range anywhere from 6.1 to 7.8 percent.

Contract and pen

Nevertheless, the IRS taxes withdrawals taken from an annuity at ordinary income rates. However, capital gains taxes do not apply here. It is also important to note that early withdrawals before age 591/2 from an annuity usually attract tax penalties (paid to the IRS), and “surrender charges,” (paid to the insurer involved).

Types of Annuities

There are three types of annuities — fixed, indexed, and variable.

How Does a Fixed Annuity Work

If you opt for a fixed annuity, your annuity payments will attract a specific interest rate. This rate generally varies depending on factors such as the prevailing economic climate. For instance, during years when interest rates are low, payout rates also tend to be low and vice versa. In general, the minimum payout rate and periodic payments are constants and they rarely change. In order to pay their clients the specified interest rates, insurers invest in corporate bonds and government bonds.

When you sign a fixed annuity contract, your insurer will guarantee that the payout rate will never fall below a specific level, which translates to a guaranteed minimum income in the future. Most insurers guarantee this payout rate for a given number of years. For example, you could choose ten years. After this period ends, your insurer will offer you a new payout rate. The renewal rate can never be lower than the minimum guaranteed payout rate.

How Does An Indexed Annuity Work

While an indexed annuity offers a guaranteed rate of return, too, it is usually linked to stock indexes such as the S&P 500 Composite Stock Price Index. Therefore, when the underlying stock index rises, the annuity involved benefits. In turn, clients get a percentage of the index gain. Experts in the insurance industry call this percentage share of index gain the “participation rate.”

In some instances, insurance companies place caps/limits on the percentage gains clients can expect. For instance, an insurer may have a gain cap of 10%. In such a scenario, percentage gains will not exceed this cap even if stock indexes like the S&P 500 rise higher. Contracts for indexed annuities specify minimum payout rates that cannot change even if the index fails to meet the insurer’s projections. However, this type of contract is generally more complex, particularly in comparison to a fixed contract.

How Does A Variable Annuity Work

This type of contract is quite unlike the others discussed above. People who buy these contracts must decide where to invest their money. For example, one may choose to invest in mutual funds. Such an investment has several advantages. To start with, insurers provide their clients with a wide range of investment options such as bonds, stocks, and money market accounts. Secondly, you do not have to invest all your money in one asset. You can diversify and put your money into various asset classes. Thirdly, an investor will enjoy substantial returns when the underlying investments rise in value. Fourthly, people who go for this investment approach enjoy tax free interest rate and dividend deposits into their accounts. One only pays tax after accessing accumulated gains. The downside to such an arrangement is returns depend on the performance of underlying investments and market losses could mean loss of principle. For this reason, variable annuities carry more risk than those described above.

How to Choose the Right Annuity Company

 

Shop Around

Before buying an annuity, you should shop around and compare offers from various insurers. Some of the aspects that you need to scrutinize carefully include payout rates, interest rates, fees and charges, as well as penalties for early withdrawals.

Financial Integrity

Choose a reputable insurance company, preferably one with a solid financial history. This is because, if an insurance company goes under, you may lose your hard-earned money. Additionally, use online resources such as the Better Business Bureau‘s website to find out whether the insurer you are eyeing has a record of mismanaging client’s money or any other type of financial fraud.

In summary, annuities provide an effective way of investing money and earn a regular income from the investment during retirement. Depending on your preference and risk appetite, you may opt to go for fixed, indexed, or variable annuities.

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