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What Is an Annuity, and Do I Need One?

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An annuity is a type of insurance product that provides you financial coverage after you retire so that you do not outlive your retirement savings. When you purchase an annuity from an insurance company, you enter into a financial contract wherein you pay a certain amount of money for a secure source of income after retirement.

Depending on the type of annuity you purchase, either a fixed, variable, or indexed interest rate is applied to the annuity so that the total amount you receive increases over time. By the time the annuity is paid out in full, you will receive the full principal amount back in addition to any gains.

Annuities offer certain tax benefits and protections that other retirement investment vehicles do not. However, they can be very complex depending on your financial situation and the type of annuity you purchase. To make sure purchasing an annuity is a smart investment, you should take the time to understand what annuities are, how they work, and whether or not they can benefit you.

How Do Annuities Work?

Image of piggy bank and a wallet with text describing differences between annuity phases

Once you’ve purchased an annuity from an insurer, they look at factors such as your current age, life expectancy, and the rate of interest added to your annuity balance to determine a payout amount. The payment period doesn’t begin until the date specified in your contract.

To better understand how annuities work, they can be broken down into two phases:

  1. Accumulation phase: The accumulation phase is when you make payments towards the annuity so that it grows. Depending on the type of annuity you purchase, you either pay one lump-sum amount or make monthly payments that continue until the payment period starts according to your contract.
  2. Payout phase: Also known as annuitization, the payout phase represents the point in time where the insurer is contractually obligated to make payments to you, the investor. Put plainly, it’s when your payments are annuitized, or converted into periodic income payments.

It’s worth noting that annuities continue to grow even after the payout phase has begun, and that funds within the annuity during the accumulation phase are tax-deferred. To learn more about how annuities work, we need to discuss the different types of annuities available.

The 5 Main Types of Annuities You Should Know About

There are five main types of annuities available, so it’s worth taking the time to understand how they work before you rush into purchasing one.

1. Fixed Annuities

Fixed annuities come with a guaranteed rate of interest. The money you invest into a fixed annuity during the accumulation phase has a guaranteed, fixed rate of return that is tax-deferred.

2. Variable Annuities

Under a variable annuity, you choose various subaccounts, or mutual funds, to invest your payments in. The value of your annuity is determined by the performance of the funds. If market volatility is a concern, you may purchase an annuity rider to guarantee an income stream that’s not affected by market performance.

3. Fixed Indexed-Annuities

A fixed-indexed annuity protects your initial investment with the potential of market growth. It offers more growth opportunity than a fixed annuity and is less risky than a variable annuity.

4. Immediate Annuities

With immediate annuities, you make a lump-sum purchase that pays a regular income amount until death or until a specified period of time. The payment period typically starts anywhere from one to 12 months after the investment has been made.

5. Deferred Annuities

If you purchase a deferred annuity, you pay a lump-sum amount for guaranteed lifetime income that starts at a future date specified in the contract. Because deferred annuities last until death, they are often compared to pensions.

Why You Should Use an Annuity

Older couple talking to a financial expert about annuities in their home.

Some people suggest purchasing an annuity only after you’ve maxed out your 401(k) and other IRAs. However, if you’re legitimately stressed about finances after retirement, then you might want to consider an annuity as well.

Annuities offer many benefits that other investment vehicles lack. For one, there is no annual contribution limit for annuities and they are tax-deferrable. Not only that, according to a recent study by Towers Watson, retirees with a predictable income are more satisfied with their lives than those without a pension or annuity. When done correctly, annuities provide financial security and comfort.

How to Get an Annuity in 3 Simple Steps

Step-by-step illustration describing the process of getting an annuity.

The process of purchasing an annuity is fairly straightforward. To get an annuity, follow these four steps:

  1. Get a quote: Annuities are sold by stockbrokers and insurance agents. Stockbrokers sell variable annuities and insurance agents sell fixed annuities. Whichever you decide to purchase, you need to first get a quote.
  2. Agree to a payment method: Once you’ve found an annuity that suits your needs, you need to determine how you will pay for the annuity. You can either choose a single premium, fixed premium, or flexible premium method.
  3. Sign a contract: After you’ve agreed to a payment method, you need to sign the contract. The insurance agent will then forward your deposit to the insurance carrier.

Upon signing your contract, you’ll be locked into the annuity for the foreseeable future. You will receive annual statements explaining how much interest your annuity accrued over time and how valuable the annuity is.

Annuities can be risky, but when planned carefully, they can provide you the financial support you may need in the future. As always, consult a financial expert to discuss your options first to make sure it’s a wise investment.

Sources: Good Financial Cents | Towers Watson

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