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Home Personal Finance
Lauren Perez
Updated
2022-07-05T16:03:15Z
- What is an annuity?
- How do annuities work?
- Immediate annuity and deferred annuity payouts
- Annuity fees
- What are the different types of annuities?
- Pros and cons of annuities
- The financial takeaway
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- An annuity is an investment product issued by an insurer that provides steady income during retirement.
- An annuity charges a premium upfront with other management fees often rolled into the cost.
- Fixed, variable, and indexed annuities offer different investment options with varying risk profiles.
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When putting away money for retirement, it can be difficult to know if you're saving enough. Even if you think you've got it all covered, there's little certainty about how much you'll actually spend or how long you'll live after you're through working.
That's where annuities come in. These unique combinations of insurance and investment features help investors save for retirement and offer assurance they won't outlive their hard-earned savings.
Learn more about annuities below and what you'll want to take into consideration before you add them to your portfolio.
What is an annuity?
An annuity is an investment you buy in exchange for periodic payouts, typically during retirement. You can make a single premium payment or a series of payments, and choose whether your annuity payouts are made in a lump sum or over time.
How do annuities work?
A modern-day annuity is a contract between you and an insurance company. In order to get an annuity, you'll need to pay a premium — usually a large lump sum — and then the insurer invests it. Afterward, the insurer provides you with a stream of payouts for a predetermined number of years or even the remainder of your lifetime.
An annuity has two phases: the accumulation phase and the annuitization phase. The accumulation phase of an annuity is the period of time when you're making payments. Those funds may be split among various investment options.
The annuitization phase is the period of time when you receive payouts from the annuity, much like a regular paycheck. This can last for a set amount of years or for the rest of your life. The payouts include the principal amount along with any investment gains.
Annuities provide a stable investment option for savers who worry about market volatility or outliving their retirement savings. Annuities are known for three main benefits.
- Reliable income for a set amount of time. Once you've made your payments, you're guaranteed to receive payouts for the rest of your life or someone else's life, like your spouse.
- Death benefits. You may also designate a beneficiary on your annuity. This beneficiary will receive the payouts if you die beforehand.
- Tax-deferred savings. Before you start receiving payouts, annuity income and investment gains grow tax free. "Annuities complement other retirement plans in that they provide opportunities to grow without heavy taxation," says Rob Williams, managing director of financial planning, retirement income, and wealth management at Charles Schwab. You pay taxes on annuity income when you receive its payouts.
What are the different types of annuities?
Different types of annuities vary in how your money is invested.
- Fixed annuities place your money in a general account of the insurance provider which promises a minimum rate of interest and fixed amount of periodic payouts. Check with your state insurance commission to confirm your insurance broker is registered to sell fixed annuities.
- Variable annuities place your money in various investments, like mutual funds, much like a 401(k). The payouts from variable annuities will vary depending on how much money you pay, the rate of return on your investments, and any expenses of those investments as well as the annuity. Variable annuities are regulated by the Securities and Exchange Commission (SEC).
- Indexed annuities provide the positive investment potential that variable annuities offer. The return of an index annuity is based on a stock market index, like the . Like fixed annuities, these are regulated by state insurance commissioners.
Pros and cons of annuities
At their core, annuities are full of advantages:
- Regular payments. They provide a guaranteed source of income throughout your retirement.
- Low-risk returns. Annuities are generally a more stable investment, unless you have a variable annuity.
- Tax-deferred growth. Earnings in your annuity are untaxed as they grow over time.
Unfortunately, there are major drawbacks to consider as well:
- Big fees. Annuities typically have high fees and commissions which can really cut back on the long-term earning potential. Because of this, annuities aren't a great place to grow money, but fixed immediate annuities take a smaller fee hit while generating a lifetime income stream.
- Illiquidity. Variable annuities don't offer access to your money until after several years, typically six to eight years but sometimes longer. If you do withdraw funds or cancel your annuity contract before that surrender period ends, you incur a surrender fee that can initially reach as high as 10% of your contributed funds, decreasing by one percentage point each consecutive year. Once your payouts start, it's next to impossible to change them or access more of your principal.
- Taxable income and tax penalties. Annuities aren't totally tax free. As a source of income, annuity payouts are subject to income tax as you receive them. If you withdraw from your annuity before you're 59 ½, you'll face a 10% penalty on top of your ordinary income tax as well.
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The bottom line
Annuities are a great addition to your retirement savings plan if you're always maxing out your 401(k) contributions and if you can afford the fees. They provide steady income throughout your retirement, they grow tax-free, and your beneficiaries can benefit from the payouts, too.
Since annuities aren't free, however, be sure to weigh their costs against their promised benefits to determine whether it's the right choice for you.
Lauren Perez is a New York City-based freelance writer who has been on the personal finance beat for five years. Her work has appeared in Forbes, MagnifyMoney, LendingTree, and SmartAsset. In addition to deposits and investing, Lauren can be found writing personal essays and covering culture.
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FAQs
What is an annuity in insurance? ›
An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments.
What is an annuity income stream? ›An annuity, also known as a lifetime or fixed-term pension, gives you a guaranteed income for a number of years. Or the rest of your life. An annuity is less flexible than an account-based pension, but you can be sure about your future income.
Is an annuity a life insurance product? ›Is an annuity a life insurance policy? No, an annuity is an investment product you purchase all at once that earns interest and, after a set time frame or when certain conditions are met, starts paying out. It may be offered by life insurance companies, but it's not technically a life insurance policy.
What is the main purpose of an annuity? ›An annuity is a long-term insurance product that provides guaranteed income. Annuities are a common source of retirement income because they provide a steady stream of payments at regular intervals and because their earnings grow tax-deferred1 until you withdraw funds.
What is an annuity quizlet? ›What is an annuity? An annuity is a contract between an individual and an insurance company. The annuitant agrees to pay the insurance company a single payment or a series of payments, and the insurance company agrees to pay the annuitant an income, starting immediately or at a later date, for a specified time period.
Who benefits from an annuity? ›Unlike other tax-deferred retirement accounts such as 401(k)s and IRAs, there is no annual contribution limit for an annuity. That allows you to put away more money for retirement, and is particularly useful for those that are closest to retirement age and need to catch up.
What are the benefits of annuity life insurance? ›Annuities are used mainly to supplement more traditional sources of retirement income such as Social Security and pension plans. Common features include: Tax-deferred growth. You will pay no income taxes on the earnings from your annuity investments until you begin making withdrawals or receiving periodic payments.
How is annuity different from life insurance? ›Life insurance provides protection for loved ones when you die; annuities provide a guaranteed lifetime income for yourself, which means you won't outlive your assets or money.
What is annuity in simple words? ›An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. An Annuity plan offers a fixed amount of money for the rest of your life in return for a lump sum payment or a series of instalments.
Which of the following best describes an annuity? ›Annuities are most accurately described as a stream of equal cash payments made at equal time intervals.
How does an annuity pay for life? ›
A life annuity is a financial product that features a predetermined periodic payout amount until the death of the annuitant. Annuitants pay premiums or make a lump-sum payment to secure a life annuity. Life annuities are commonly used to provide or supplement retirement income.
Is income stream same as an annuity? ›A super income stream (also known as a super pension or annuity) is a series of periodic payments to a member. An income stream is either: account-based – the income stream is paid from a super account held in the member's name.
Do annuities provide lifetime income? ›An annuity with a guaranteed lifetime income can be an important part of your retirement income plan, providing guaranteed 1 income for a specific period of time or the rest of your life.
Are annuities a good source of income? ›Annuities can provide a reliable income stream in retirement, but if you die too soon, you may not get your money's worth. Annuities often have high fees compared to mutual funds and other investments. You can customize an annuity to fit your needs, but you'll usually have to pay more or accept a lower monthly income.
What is the main purpose of an annuity quizlet? ›The basic function of an annuity is to systematically liquidate a principal sum over a specified period of time. An annuity is usually purchased as a means to save for retirement. The benefit of purchasing an annuity is that the cash accumulation in the account grows tax deferred.
What is annuity income called? ›An income annuity, also known as an immediate annuity, a single-premium immediate annuity (SPIA), or an immediate payment annuity, is typically purchased with a lump sum payment (premium), often by individuals who are retired or are close to retirement.
What is an annuity called? ›The term "annuity" refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments.
What are annuities pros and cons? ›Annuities can offer guaranteed income in retirement, but there are pros and cons. Pros include guaranteed income, customization, and tax-deferred growth. Cons include complexity, high fees, and less access to your money if you need it early.
Which is better annuity or life insurance? ›Both annuities and life insurance should be considered in your long-term financial plan. While both include death benefits, you buy life insurance in the event you die too soon and an annuity in case you live too long.
How long does an annuity last? ›The annuity will provide payments for that fixed period. Once the term ends, payments will stop — even if the annuitant is still alive. Periods can last five to 30 years.
How does an annuity work when you retire? ›
Retirement annuities promise lifetime guaranteed monthly or annual income for a retiree until their death. These annuities are often funded years in advance, either in a lump sum or through a series of regular payments, and they may return fixed or variable cash flows later on.
What is an example of an annuity? ›In investment, an annuity is a series of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments and pension payments. Annuities can be classified by the frequency of payment dates.
Which of the following is generally true of an annuity? ›Answer and Explanation: The correct answer is c) An annuity due is an equal stream of cash flows paid or received at the beginning of each period.
Which of the following accurately describes the role of the annuitant? ›An annuitant is an individual who is entitled to collect the regular payments of a pension or an annuity investment. The annuitant may be the contract holder or another person, such as a surviving spouse.
Which of the following is a type of annuity? ›There are four basic types of annuities to meet your needs: immediate fixed, immediate variable, deferred fixed, and deferred variable annuities.
Can you live off of annuities? ›This is where a guaranteed lifetime income rider comes in. This rider ensures that monthly payments will continue to be made, even if the account balance is gone. As a result, annuity owners can rest assured that they will never outlive their income.
What is an annuity and how does it work? ›They're long-term contracts from an insurance company where you invest your money. In return for your investment, you get income in the form of regular payments through annuitization or a guaranteed lifetime income benefit that is available at an additional cost.
What is an annuity in simple terms? ›An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.
How much does a 100 000 000 annuity pay per month? ›A $100,000 annuity would pay you approximately $508 each month for the rest of your life if you purchased the annuity at age 60 and began taking payments immediately.
Can you make money with an annuity? ›Annuities can provide a reliable income stream in retirement, but if you die too soon, you may not get your money's worth. Annuities often have high fees compared to mutual funds and other investments. You can customize an annuity to fit your needs, but you'll usually have to pay more or accept a lower monthly income.
Do annuities provide income? ›
Income annuity features and benefits
Immediate income annuities start paying income right away; deferred income annuities provide guaranteed income in the future. Deferred income annuities typically provide a death benefit before income payments begin.
The annuity will provide payments for that fixed period. Once the term ends, payments will stop — even if the annuitant is still alive. Periods can last five to 30 years.
Do you keep your money in an annuity? ›Annuity owners can lose money in a variable annuity or index-linked annuities. However, owners can not lose money in an immediate annuity, fixed annuity, fixed index annuity, deferred income annuity, long-term care annuity, or Medicaid annuity.
What are the 4 types of annuities? ›- Immediate annuities: The lifetime guaranteed option. ...
- Deferred annuities: The tax-deferred option. ...
- Fixed annuities: The lower-risk option. ...
- Variable annuities: The potentially highest upside option.
Example of an Annuity
A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during their retirement years.
The guaranteed monthly payments you will receive for the rest of your life are roughly $5,083 if you purchase a $1 million annuity at age 60.
How much does a $2000000 annuity pay per month? ›How much does a $200,000 annuity pay per month? A $200,000 annuity would pay you approximately $876 each month for the rest of your life if you purchased the annuity at age 60 and began taking payments immediately.
Should I buy an annuity at age 70? ›Investing in an income annuity should be considered as part of an overall strategy that includes growth assets that can help offset inflation throughout your lifetime. Most financial advisors will tell you that the best age for starting an income annuity is between 70 and 75, which allows for the maximum payout.