Annuities – What is an Annuity?

 

Note: Please see the bottom of the article for additional annuity links and information

 

An annuity is a long term financial product, purchased through an insurance company, that helps fund your retirement. You give the insurance company a sum of money which is called a premium. This premium can either be a lump sum or periodic payments and then a stream of payments will be paid out to you within a specific time frame. Annuities seem pretty straightforward; however they can become very complicated.

 

It is important to never invest in something you do not completely understand. Therefore, do not let an insurance agent talk you in to a financial product you do not fully understand. You should do your own research on the annuity. It may take some time, but you will have more knowledge on the product you are purchasing.  It is important to protect yourself because an insurance agent might only suggest an annuity with the largest commission.

 

It is important to know about the different types of annuities and the stages of annuities. These concepts will be covered later on. The fundamentals of annuities are important to understand. You should ask yourself, is the annuity safe, how are they taxed, and what are the rate of returns. These questions can be answered by knowing the six features of an annuity. These are features that every person looking to invest in an annuity should know.

 

The first feature is an annuity rider. A rider is an optional annuity benefit. Riders are the main aspect of a variable annuity. Death benefits and living benefits are the two categories of riders. Riders are come at an extra fee; however they do offer to increase the contract’s income-generating ability or death benefit payout.

 

Another feature to be familiar with is annuity fees. Fees are usually associated with variable annuities. Variable annuities have many annual fees such as basic insurance administration and expenses, and optional feature add-on expenses. Some annuity companies might offer low annual expense fees, therefore you should compare the fees of multiple annuities. Variable annuities usually charge the fees annually. The fees can impact the investment returns and can result in large sums paid out over time.

 

The next feature is annuity returns. Most annuity policies are sold with a guarantee that provides some principal protection or base-level return. These types of guarantees include higher fees compared to other options. However performance caps or participation rate might limit high returns.  Variable annuities have multiple fees that pay for the underlying insurance features and investment funds; therefore they are unlikely to produce significant returns in the long run.  Returns on variable annuities are not stable. Fixed-indexed annuities guarantee a minimum return and offer a variable interest rate based on an equity index. However, a cap, spread, or participation rate might limit overall returns to a suitable level for the insurance company. Fixed annuities provide a steady return but inflation might change the amount that is paid out.

 

Another feature to understand is liquidity of the annuity. When purchasing an annuity, you should be familiar with the liquidity issues with annuities. All annuities carry a liquidity risk. If you withdrawal any amount prior to the age of 59 ½ or before the surrender period is over, you are subject to a penalty from the IRS. Most annuities have high surrender fees such as 10-15% then decline over the 10 year period. Withdrawing money during this period could reduce your gains.  Since the market is constantly fluctuating, your current balance in a variable annuity might not be same when you are ready to withdraw.

 

You should also be aware of annuity taxes. Annuities can either be taxable or tax-deferred. Money that you invest in an annuity grows tax-deferred. When you decide to make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate. Taxable annuities do have an attractive tax-deferral status that allows for the tax-free growth of funds within the annuity. Therefore, depending on your income level and tax status, this can be a positive or a negative. However, it could take many years for tax deferrals to produce a significant return.

 

The final feature to understand is insurer financial strength. The insurance company’s financial strength is a main aspect in its ability to pay benefits over time. Investors are unlikely to lose the principal in the event of an insurer default; however any add-on benefits or contractual guarantees might not be recognized.

 

It is also important to know the different stages of an annuity. An annuity can go through an accumulation phase and annuitization phase. Deferred annuities start in the accumulation phase. During this phase, the owner of the annuity makes payments to increase the value of the annuity to use for retirement. Remember that if you make withdrawals during this time, you might be charged high surrender fees, income tax and a 10% federal penalty tax if you are under age 59½. Deferred annuity owners rarely have to go through annuitization phase. Annuitization phase applies to immediate annuities.  In this phase, the contract value is shifted to the insurance company in exchange for a stream of payments. These payments can either be for life or a set period of time. An immediate annuity automatically starts in the annuitization phase; however you can convert a deferred annuity into an immediate annuity to collect a steady stream of payments.

 

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