Annuity: What It Means and How It Works

What is an annuity?

An annuity is an investment option that guarantees you or your spouse income for a set period of time, usually during retirement. Annuities are purchased to pay a set specific amount based on the amount invested and the chosen investment strategy. 

When purchasing an annuity a contract is signed between the individual and an insurance company. The person (called an “annuitant”) either makes a lump sum payment or pays a monthly premium to buy the annuity. These funds are then paid out by the insurance company to the individual, or their spouse,  in the future for a specified amount of time or for the rest of their life. 

After purchasing an annuity, a person must wait sometime before withdrawing funds to avoid paying a penalty. This waiting period is known as the surrender period and can last anywhere from two to 10 years. 

Annuities are a common type of retirement investment. They provide a steady stream of income during your retirement years -– much like a salary or pension -– to supplement your other retirement income. 

Types of annuity

There are three main types of annuity: fixed, variable, and indexed. 

Fixed annuities pay out a guaranteed amount over a specific period of time or for life. Fixed immediate annuities begin paying out as soon as you purchase them, while a fixed deferred annuity pays out on a pre-decided date. 

Variable annuities could potentially give you a higher return but are riskier. These funds are invested in mutual funds and the payments you get in return are based on how the mutual fund investments perform. 

Indexed annuities are in between – there is a bit of risk but some sense of security. With an indexed annuity there is a guaranteed minimum payout, but part of it depends on the performance of stock market indices like the S&P 500 or Dow Jones Industrial Average (DJIA). If these indexes don’t perform well, you may receive lower returns for a period.  

Both variable and indexed annuities tend to have higher commissions and other fees. 

Things to keep in mind before buying an annuity

Though an annuity is generally a retirement investment, there is no fixed age to purchase one. Anyone looking for a steady income post-retirement or with a large lump sum to spare may consider annuities as a good investment. 

Annuities don’t come with capital gains, so it may not be a good idea for those who are looking for appreciation. Annuities also come with high sales and commission charges. 

If you need your funds to be liquid, you should explore other options since the lock-in period for an annuity is longer. 

The funds you invest in an annuity do not reduce your taxable income. This is why it is usually recommended that you buy an annuity only after you have contributed as much as you can to your tax-advantaged retirement accounts for the year, like a 401(K), 403(B), and IRA. The monthly payouts you receive from an annuity are taxed at regular income tax rates. If you are looking for tax rebates through investments, annuities may not be for you. 

Make sure to understand all the terms of the annuity before deciding it is the best option for you. Employer-sponsored and individual retirement plans are other great options that come with tax benefits.

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StellarFinance, Inc. does not necessarily constitute or imply its endorsement, recommendation or favoring, sponsorship, or representation in reference to any specific company, products, processes, or services by trade name, trademark, manufacturer, or otherwise in this article. StellarFinance, Inc. and its affiliates do not provide financial, tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own financial, tax, legal and accounting advisors before engaging in any transaction.