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What is an Annuity and How Does it Work?

An annuity is an investment option that can provide a guaranteed income for an individual or their spouse throughout their retirement. They are purchased for a set period and payout a specific amount in retirement based on the investment strategy and amount invested.

Annuities tend to be good for people that want the option of a lifetime income during their retirement and may have concerns about outliving their savings. There are other factors that should be taken into consideration before getting an annuity. Annuities are designed to be a long-term component of a financial plan along with other retirement income streams.

How Annuities Work

  1. Participants select an annuity type and pay into a plan purchased through an insurance company.

  2. The insurance company invests the payment from the annuitant, so the account earns interest on top of the original amount invested for the duration of the contract.

  3. Once the annuitant decides to receive payments from the annuity, payments will be made up of a return of the original investment plus interest, minus fees.

  4. The annuitant receives income during the retirement period.

In considering an annuity, it is important to understand, other than contractual withdrawal amounts, the money invested usually is not accessible until the annuity payout begins.

Types of Annuities

There are several types of annuities to choose from. Before selecting, consider financial goals for the future, the timeframe for when a payout is desired and fee structure.

Immediate Annuity
Payout starts shortly after a single premium payment is made.
Deferred Annuity
Payout starts at a set date in the future. Why isn't this working.
Fixed Annuity
Payout based on an amount guaranteed in the contract. Payments are normally fixed and the insurance company bears the investment risk.
Indexed Annuity
Provides a guaranteed return with the option of sharing in investment market earnings.
Variable Annuity
Accumulation and payout are variable and not guaranteed, although contracts may offer minimum guarantees as an option.

Annuities offer tax-deferred earnings

Taxes are applied to an annuity when the money is paid out, but not while the money is in the account. The delayed taxation helps account values grow more than if they were subject to ongoing taxation. Annuities vary widely – by terms, fees, structure, payouts, penalties and possible (or acceptable) changes – allowing for customizable plans. A fixed annuity is one of the most predictable financial investments – with guaranteed payments and duration – which offer peace of mind when payouts begin. Annuities can also help resolve concerns around finances and longevity.

If the plan is originally purchased with funds that are not taxed (such as a 403(b) plan), all distributions are taxable. Consult a tax advisor for more information on the structures and implications.

Annuities have standard fees associated with them that vary from company and annuity type. Fees cover administrative costs and mortality expenses. There may be withdrawal fees if payments are taken before the predetermined period.

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