How Does An Annuity Work?

With the cost of living rising steadily, it is important to invest one's money in financial instruments that secure your future. You may have heard of annuities and wonder how does an annuity work. It is basically a contract between an investor and an insurance or investment company, wherein one invests money regularly or in a lump sum, and receives returns immediately or defers them.

There are several advantages to investing in an annuity. First is the fact that you can slowly build up a nest egg and secure your retired years. Putting your money into annuities allows you to create a retirement plan beyond the conventional retirement solutions. Furthermore, there are no limits on the amount that one can invest in such a financial vehicle. The sooner you invest in an annuity, the lower the payment sum. Usually it will offer returns close to one's age of retirement. It is important to buy a financial product after careful consideration as premature withdrawals attract penalties.

This form of investment is not just great for people who have a long period of employment ahead of them, but also for those who are about to retire. It is a great way to plan one's estate and by nominating a beneficiary, you can leave money for your heirs. It also offers a tax advantage as only the money received from payouts is taxed.

There are many different types of annuities, and this makes it an ideal investment vehicle for people with varied investment requirements. If you have a large sum of money to invest, you can choose an immediate annuity that would offer a regular source of income for a fixed period of time. A deferred investment plan is excellent for people who want to use their investment for tax planning and to postpone the payout.

You can also make a choice based on the amount of risk that you are willing to bear. Fixed annuities offer a low and fixed rate of interest. On the other hand, variable ones are linked to the performance of the stock market and they offer a varied rate of interest on your savings. It is important to choose an annuity that suits your financial needs and expectations. Before one is willing to sign on the dotted line, it is crucial to read the details regarding payouts, withdrawals and taxation, so that you make an informed and wise choice.

 

Are Annuities A Good Investment?

Those who are in the process of planning their retirement may find themselves asking the question "Are annuities a good investment?" Annuities are investment products issued by an insurance company and are backed by the company's financial strength. Annuities provide tax-deferred income growth. When an individual retires, an annuity offers him or her a guaranteed income stream for a specified period. Annuities also provide a buffer against market downturns as they can grow tax-sheltered until the money is withdrawn.

Variable and Fixed Annuities

Typically, the return on a fixed annuity is a set amount regardless of whether it is in its accumulation phase--when one is adding to the investment--or during withdrawal time. It is for this reason the annuity is referred to as "fixed." It is important to understand, however, that this does not mean the annuity's rate will not vary as time goes by, it simply means that there are certain stipulations concerning how and when the rate can change.

With a variable annuity, one places his or her money in sub-accounts during the annuity's accumulation period. The return of these investments is dependent upon on the performance of the sub-accounts one selects. To make this decision, many individuals seek the advice of a financial planner although this is certainly not a requirement. A person's choice of sub-accounts is usually similar to those, which would be made if the money were being invested in mutual funds.

Owning variable annuities can sometimes be expensive, as one must pay an expense and mortality risk charge, which is typically 1.15 % annually. There are also investment administration expenses associated with variable annuities and these can sometimes be as high as 2% annually. For some, this results in a drag on the annuity's investment return.

Additional Considerations

All types of annuities have surrender charges, which their owners must pay if the money is withdrawn early. In addition, withdrawals made by individuals who are less than 59 ½ years of age are subject to an IRS tax penalty of 10 %. With this in mind, older individuals may find more benefits than younger persons in such investments.

A guaranteed lifelong income is an appealing feature to anyone concerned with his or her financial future. The aforementioned early withdrawal penalties may result in a considerable amount being lost from the principal value. However, if one is confident that early withdrawal will not be necessary, an annuity is one of the best long-term investments available.

 

How Do Deferred Annuities Work?

Annuities originally were funded by one lump sum deposit and they began paying monthly installments within one year from the date of that deposit. Today, however, they can be funded over a period of time with smaller deposit amounts and monthly distributions can be deferred for many years. This article provides general information to answer the question, "How do deferred annuities work?"

The phase in which money is being deposited into a deferred annuity is called the deferred phase or the accumulation phase. During this period, the funds deposited and the accumulated interest earned is both tax deferred, meaning taxes are not paid on the money until it is distributed from the account. Annuities are commonly used as retirement vehicles and since most people are in a lower tax bracket during retirement, deferring taxes generally results in severely decreased tax obligations. Distributions typically start when the account holder reaches a minimum of 59 ½ years of age, but most contracts also allow for up to 10% of the balance to be withdrawn annually without penalty. Early withdrawals in excess of the contracted amount will result in a 10% tax penalty imposed by the Internal Revenue Service and an additional 1-10% surrender charge imposed by the insurance company that sponsors the account.

Once the account has reached its contracted maturity, the next phase begins. This is known as the distribution or income phase, as the monthly withdrawals, or distributions, often replace a retirees former income source or paycheck. Several options exist for the timeframe of the distributions. Some people choose annuities that only last for a set number of years. Others choose lifetime annuities. These accounts were developed to provide income for a person's life, even if the person outlives the account balance. The original design called for any outstanding balances to be abandoned if the person died before the funds were distributed, allowing the funds to revert to the insurance company. Today, most accounts have provisions to leave any undistributed funds to the account holder's beneficiary of choice.

Interest is earned on deferred annuities in several different methods, depending on the account. Fixed interest rates generally lock in that rate for a specified time period such as one year. Because the rate becomes variable after the guaranteed timeframe expires, most contracts offer a bailout clause that allows the account holder to move the funds from the annuity without penalty. Variable rate accounts are riskier, but with great risks come great rewards. If the rates drop, the annuity can lose a considerable amount of money. Adversely, if the rates soar, the annuity can earn a substantially higher return than a fixed account could ever produce. Index deferred annuities offer a more conservative choice that offers higher interest rates than fixed accounts. The interest rates on these accounts are tied to an equity index like the Standard & Poor's 500, which provides more security than variable accounts. To determine the most appropriate and beneficial deferred annuity, an individual should always properly research the available products and rates on the market.

 

How Annuities Work

In many ways, annuities function much as Certificates of Deposit ("CDs") or savings accounts. An initial lump-sum deposit is made into a specialized investment account. Future periodic payments may also be required. The investor allows all funds to remain intact for a pre-specified period of time. Typically, the minimum time period is 5 years; however, it may be as long as 20 to 30 years. In financial parlance, this period of years is called the investment "term."

Expiration of this term is known as "maturity." At maturity, previously invested funds may be withdrawn or reinvested at your option. Ideally, the investment will have increased substantially by maturity, due to interest earned on all deposits.

Unlike CDs and other liquid investment accounts, an annuity is also an insurance contract. In addition to investment returns, you receive life insurance covering during the annuity contract term. If you expire before the annuity term does, your heirs receive the face amount of the life insurance policy.

Annuity Advantages

Annuities' main advantage is tax deferral. Interest earned on invested funds is not taxed until withdrawal. Suppose you are in the 25 percent tax bracket and your average rate of return on a CD is 6 percent annually, you will net only 3.5 percent.

By contrast, Uncle Sam's hand cannot touch your 6 percent annual annuity returns. Unlike a CD, an annuity is not a liquid financial account.

When you finally settle down and claim your nest egg after a few decades, you may choose how to receive your well-deserved windfall. You may turn the tables and receive monthly income. Uncle Sam's tax bite is not nearly as bad with relatively small monthly disbursements as opposed to a single mega payoff.

You may even decide just to let all that loot sit there and do its thing all over again. Leave it alone and let it become a living legacy for your heirs. Uncle Sam will just have to be patient a little longer. The compounded interest remains tax-deferred.

What is better is that your bottom line will be much better for the wear after many years, due to annuities' historically high investment performance. The paltry returns banks offer on CDs cannot hold a candle to the bright outlook that paves your way to a comfortable retirement with annuity investment.

Something For Everyone

Annuities come in "fixed" and "variable" varieties. Fixed annuities provide a set rate of future income at a guaranteed minimum level. Variable annuities offer future income based upon market performance of specific annuity subaccounts such as mutual funds or stocks. Consult an investment advisor today to learn more about how annuities work.


 

What Is An Annuity And How Does It Work?

Many types of accounts are available for consideration when planning for one's future or retirement. One such type of account is an annuity, which is an effective way to produce residual monthly income that will help supplement Social Security benefits or pension accounts. If you are wondering what is an annuity and how does it work, read on for a brief explanation.

An annuity is a savings vehicle offered through insurance companies by investment specialists. Investment specialists are often affiliated with banks and credit unions so they can offer financial products right at the institution for the customers' convenience. Even though they may be obtained at a financial institution, annuities are not insured through the Federal Deposit Insurance Corporation or the National Credit Union Administration.  In fact, annuities are most often often through a company's insurance division.

There are two basic types of annuities: immediate and deferred. Immediate annuities are funded in one lump sum deposit and they start paying back the money to the investor right away in monthly installments. Deferred annuities are opened with a smaller deposit and they allow the investor to increase the balance by making regular contributions, usually on a monthly basis. The period of time that deposits are being made into the account is called the deferral phase. This gives way to the income phase, or the period of repayment to the investor. As with an immediate annuity, a deferred annuity pays monthly installment to the account owner during the income phase.

The interest earned on an annuity can be at a variable rate or fixed rate. Fixed rates often have a minimum amount that the interest will not fall below without actually guaranteeing a set rate of interest. Either payments are made for a predetermined amount of time or they can continue for the lifetime of the account owner. Lifetime annuities will keep paying monthly installments even if the account funds are exhausted, while annuities with a predetermined maturity date will not pay beyond that time.

Many people choose to transfer the balances of their 401K accounts into annuities when they retire. The monthly annuity installment payments take place of a person's paycheck, making the transition to retirement easy. There are also many tax benefits associated with annuities. To find the best account that is most beneficial to an individual's financial situation, it is advisable to seek professional help. Most financial planners and investment specialists offer free consultations with no obligations. They will review the person's current situation and future needs and direct him or her to the right vehicle to make retirement a more enjoyable time of life.

 

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