Annuity 101: What You Need to Know

Annuity 101: What You Need to Know

Any person nearing retirement experiences two emotions—joy and dread. Joy, because after decades of hard work, they can finally sit back and enjoy the fruits of their labor, pursue a lifelong hobby or dream, and spend more time with their family. They dread because the future is uncertain—there might be a sickness or unscheduled expenses.

Even with a pension, there are no guarantees of a stress-free financial life. But you can make things lighter and you can prepare by buying an annuity from one of the many annuity marketing organizations out there.

What is an annuity?

An annuity is an agreement with an insurance provider that lets you pay an amount—whether in a lump sum or in a series of payments—and in exchange, you will receive regular payments back, much like a regular income. You could choose to get the money immediately or some other time in the future, say after retirement.

An annuity’s purpose is simple: provide income continuously even after retirement.

The beauty of annuity is that it can be customized to fit the needs of the recipient. The option of when to annuitize your contributions (start receiving payments) is entirely up to you—it could be immediately, as in the Immediate Annuity, or it could be at a later date, which is called a Deferred Annuity.

Disbursement options also exist. Payments can be received over a set amount of time—say 20 years—, or it may be until your death. Lifetime payments reduce the amount you receive, but the advantage is that you are sure you will not wake up one day and see that the well is dry.

Types of Annuities

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There are three types of annuities and each presents its own unique risk level and payout potential. Find out which one works best for you.

Fixed Annuities. This pays out a guaranteed amount, based solely on your account balance. With this guarantee, it is expected that it would only yield a modest return.

Variable Annuities. Higher returns call for taking greater risks and this is what variable annuities are. You, as the investor, will choose from a menu of mutual funds and this becomes your sub-account. The money you will receive after retirement will be based on the market performance of your chosen investments in the sub-account.

Indexed Annuities. With this option, you will receive a guaranteed minimum payout. But a part of the disbursement is bound to market index performance. An example of this is the S&P 500.

The potential earnings for both the variable and fixed annuities are greater, although the process of choosing the annuity or investment does present a challenge for some.

Tax and Annuities

It’s important to know that any type of annuity has its tax feature. Your balance does grow tax-free, but your disbursements are subject to income tax. Moreover, mutual funds held for over are year are taxed at the rate of long-term capital gains, and unlike 401(k) accounts, annuities contributions do not reduce taxable income. Experts, therefore, recommend annuities only after contributions to pretax retirement accounts are maximized.

An annuity plan is an insurance product that holds a lot of potential for the investor and his or her beneficiary. You can generate lifetime income while saving for retirement minus market risk, and then leave something for your loved ones after you pass away.

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