How Does An Annuity Work?

Annuities are considered long term financial vehicles that are designed primarily to help investors from outliving their income in retirement. An annuity is an insurance contract that is issued by an insurance company.

The money that is saved in an annuity – either in one lump sum, or through periodic deposits over time – can be converted into income payments that can last for a person’s (or for two people’s) lifetime, regardless of how long that may be.

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Types of Annuities.

There are several different choices when it comes to types of annuities. The right annuity for an investor will depend on a person’s specific goals, risk tolerance, and investment time horizon.  The types of annuities that are available in the market today include:

Fixed.

With a fixed annuity, the issuing insurance company will guarantee both the principal and the earnings, and it will make fixed dollar payments throughout the chosen term of the contract.
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Variable.

With a variable annuity, the issuing insurer will guarantee a minimum amount of income payment. However, the remaining income payments will vary based on the performance of an underlying portfolio. This allows the opportunity for larger payments, but it can also present more risk.

Index.

The performance of an index annuity will be dependent upon an underlying market index, such as the S&P 500. These annuities allow for upside market opportunity (that is typically capped at a certain percentage), along with downside protection in a poorly performing market environment.
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Guaranteed Income For Life. Just One of the Many Advantages of an Annuity.

There are Many Benefits to Owning an Annuity. These Can Include.

Tax Deferred Growth.

The funds that are inside of an annuity are allowed to grow on a tax deferred basis. This means that there is no tax due on the gain until the time that the money is withdrawn. This can be many years down the road.

Income for Life.

If the lifetime payout option is chosen, an annuity can provide an income for the remainder of an individual’s life – and if the joint life option is chosen, it will provide guaranteed lifetime income for a second named individual, such as a spouse or partner, as well. Because of this, an annuity can literally provide an income that cannot be outlived.

Compounded Interest.

Due to the tax deferred aspect of annuities, interest can essentially compound on top of interest. In other words, because a prior year’s interest was not taxed, the investor can get the benefit of obtaining even more interest the following year on top of that, and so on.

Phases of an Annuity.

Annuities have two key phases in their life spans. These include the accumulation phase and the annuitization phase.

The accumulation phase:

The accumulation phase is the period when the annuity holder is making deposits into the annuity. This may encompass a long period of time where many contributions are being made, or conversely, it may be just one large lump sum contribution.

The annuitization phase:

The annuitization phase is when the annuity starts to make income payments. This occurs when the money that has been deposited into the annuity is essentially converted over from savings into an ongoing income stream.

Annuity Payout Options.

Annuities typically have a variety of different payout options to choose from. These can include:

  • Period Certain – With a period certain annuity payout option, the annuity will pay out a regular recurring income payment for a set number of years, no matter how long the recipient (annuitant) lives.
  • Life Only – The life only annuity payout option will provide the annuitant with recurring income payments for the remainder of his or her life – regardless of how long that may be.
  • Life with Period Certain – The life with period certain annuity payout option will combine the benefits of the period certain with the life only in that it offers payments for the rest of the annuitant’s life, but if that person passes away shortly after the income begins, then a named beneficiary will still receive income from the annuity for a set number of years.
  • Joint Life – The joint life annuity payout option is often chosen by couples who want to be sure that both individuals will receive income for the remainder of each of their lives. Here, the income payments will continue until each person has passed away.
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