What is an Annuity
An annuity is a contract
between the annuity owner and an insurance company which provides
tax-deferred growth from which regular income payments may be received at
retirement. The owner agrees to pay a premium (either in a single lump sum
or in periodic installments, depending on the terms of the contract). In
turn, the insurer agrees to credit the premiums with interest and to convert
the premiums and interest into a steady stream of payments to the owner by a
specified date. Under federal tax laws, the owner does not have to pay any
federal income taxes on the amounts earned within the annuity until he or
she either takes withdrawals from it, or until the annuity is annuitized
(converted into a stream of payments). Annuities are intended to be
long-term investments that are often used to save for retirement.
involved in an annuity?
There are three parties to
an annuity: the owner, the annuitant, and the insurer. The owner controls
the contract, and can exercise contract provisions, such as withdrawals,
designating beneficiaries, etc. The annuitant is the measuring life; for
example, if the owner decides to annuitize, those payments may be made for
the life of the annuitant, not the owner. Usually, the owner and the
annuitant are the same person, but this is not always the case. The final
party is the insurance company, which issues the annuity.
Types of Annuities:
In a fixed or fixed rate annuity, the insurer invests premiums in a
portfolio of long term financial instruments, such as bonds and mortgages.
Depending on the rate of return the insurer is able to earn on these
investments, it will declare a rate which will be credited to all money
invested in the annuity. These rates are generally not guaranteed (although
there may be a minimum guarantee), and are subject to change by the insurer
as changes in the earnings on its portfolio warrant. However, once a rate is
credited to the value of the annuity, the annuity value will not go down
even if the insurer's underlying portfolio goes down in value. In other
words, the insurer bears the risk of changes in market conditions.
The opposite is true with variable annuities. In a variable annuity,
the owner can allocate premiums and cash values among several different
funds or sub accounts. These sub accounts may include diversified stock
funds, bond funds, money market accounts, or other more specialized types of
investments. The important thing to remember is that the value of the
annuity usually will reflect the performance of the underlying funds in
which those values are invested; that is, the owner bears the market risk in
a variable annuity. However, a
variable annuity also has the potential for higher returns than a fixed
When do Annuities payments start?
immediate annuity, payments begin immediately or within one year from the
date the annuity is purchased. There is no "accumulation" phase.
Immediate annuities are often purchased on a single premium basis.
A deferred annuity is a
contract which allows the owner to annuitize more than six months after the
annuity is purchased. The annuity thus has two phases: a
"deferral" or "accumulation" phase and a
"payout" phase. The annuity owner usually can access the annuity
values during the accumulation phase by making withdrawals. However,
withdrawals may be subject to surrender charges, and if made before age 59
1/2, to a 10% IRS penalty tax as well. Upon annuitization, the value that
accumulated during the "deferral" (accumulation) phase may be
applied to make payments under the payout option selected.
you consider purchasing an annuity?
Annuities should be
considered by individuals with the need to accumulate funds for long-term
goals. Because annuities offer the opportunity to take distributions either
by withdrawals (deferred annuities only) or by annuitizing the contract,
they are an excellent choice for retirement savings. They can also be used
to manage a large sum of money (such as an inheritance or court settlement)
for the long term.
else I should know?
First, annuities generally have
surrender charges, expenses, and contract fees. This usually makes them
unsuitable as short term investment vehicles, since these costs will impact
the value of the contract. Also, once annuitization begins, it is
Secondly, fixed annuities are backed by
the insurance company that issues them. Although annuities are sometimes
sold by banks, they are not FDIC insured, nor are they backed by the bank
which sells the annuity.