How Do Annuities Work?
- With an annuity, you generally pay now in order to guarantee that you will receive a series of payments that will begin either now or later.
- The duration of payments you receive can be spread over a set period—a few years, for example—or for the rest of your life.
- Payments to you can be made monthly or in a lump sum annually, for example. You can also make your initial investment in a lump sum or in payments over time.
- Based on the type of annuity you choose, the payments may also be set to last for your spouse’s lifetime, as well. With certain types of annuity, if you die before receiving all the payments you are due, a beneficiary can inherit the remaining benefits.
- There are also annuities that adjust payments based on inflation.
What Types of Annuities Are Available?
- Immediate annuity: You buy an annuity, generally with a lump sum payment, and receive payments that begin immediately, lasting for a set period or your lifetime.
- Deferred annuity: You buy the annuity now and begin to receive payments after a certain number of years. If, for example, you think you have enough retirement funds to cover your needs until age 75, you might buy an annuity that would start paying benefits when you hit that age and that would last the rest of your lifetime.
How Is My Money Invested?
- Fixed annuity: The investment and the return are guaranteed. You receive fixed payments for the entire term of the annuity.
- Variable annuity: Your return is based on the performance of investments that you choose.
- Equity indexed annuity: Your return is based on the performance of a specific index, such as the S&P 500.
What Are the Benefits of Annuities?
- With a lifetime annuity, you will not outlive your payments.
- There can be tax advantages, including deferral of taxes on earnings.
- There are no limits on annual contributions, unlike with retirement saving accounts (unless your annuity is held in a retirement account like an IRA).
- With a fixed annuity, your principal and interest are guaranteed.
- Annuities with a death benefit can provide payments to your spouse and possibly beneficiaries.
- Your heirs can avoid the probate process if they are named as beneficiaries.
What Are the Drawbacks?
- There may be commission charges when you buy the annuity.
- Some withdrawals are taxable. Any made before you reach age 59½ can be subject to income tax and a penalty.
- There may be potentially hefty surrender charges for early withdrawals. Find out the details in advance so you aren’t surprised if you need the money unexpectedly later.
- Your earnings and principal on a variable annuity can fluctuate, and there may be high fees on these investments.
- You could lose your money if the company that sold you the annuity goes out of business. With insurance companies, you can check their financial stability with credit rating organizations such as A.M. Best, Standard & Poor's and Moody's.
- Your beneficiaries (other than a spouse) must pay tax on any deferred earnings from what’s considered a “nonqualified” annuity as ordinary income when they inherit.