How does an Annuity Work?

An annuity is another way to consider saving for retirement. Most people are no longer relying on just social security payments to fund their retirement. In addition to 401(k) plans, IRA’s, and traditional savings accounts, annuities are just another option for those looking to ensure the lifestyle they desire during their retirement years.

What is an Annuity?

Essentially an annuity is a contract that one makes with the company they choose, making payments in return for a payout in the future. There are many places to purchase an annuity, from insurance companies, to banks, brokerage houses, mutual fund companies, and even nonprofit organizations. The payment period for an annuity depends on how early you purchase the annuity and what the terms of the contract are. In that same regard, the payout period can also differ based on your contract.

Payments into an annuity can be made in one lump sum or broken up over time. This is also true of the payout. You can choose to have one lump sum pay out, or have payments made to you monthly, quarterly, or yearly.

There are two types of annuities, fixed and variable.

Fixed annuity

This type of annuity guarantees a certain future payment. Fixed annuities are typically purchased by the very cautious investor, or those purchasing late or close to retirement age. The return rates on fixed annuities are generally low, and the tables are based on a person living to be 100 years old.

Variable annuity

This type of annuity is more risky. You decide where to invest your money and the size of your payout depends on the performance of your investments. Typically it can take from 5 to 15 years for the best payout from a variable annuity. However the profit is usually much greater then that of a fixed annuity.

Benefits of an Annuity

Any form of retirement savings is beneficial. Purchasing an annuity is a good way to invest money that is not eligible for traditional retirement savings. Because employee retirement plans like 401 (k)’s and IRA’s limit the amount of money you can contribute annually, having an annuity is another way to add to retirement savings. The money invested in an annuity is tax-deferred.

If the owner of an annuity names a beneficiary, the beneficiary will get the payout should the annuity holder pass away before the payout period is complete. They may either choose a lump sum payment, or get periodic payments. Many look at this type of investment as a way to leave behind money for their heirs.

Drawbacks

Any type of investment can be risky, especially when you are depending on the performance of stocks, so that is something to consider. With an annuity, while you don’t pay any tax initially, you do have to pay tax on on the payouts once they start. Also, if for some reason you need to withdraw money, there is usually a penalty for early withdrawal. You can be charged around 10% by the IRS if you try to withdraw from your annuity before age 59 ½, and the company can also charge you a fee.

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