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what is an annuity

An annuity is a financial contract you can sign with an insurance company, wherein you pay a premium in exchange for guaranteed payments at a later date. Annuities can be a useful tool to help you fund your retirement. If you’re worried that you might outlive the savings you’ve built with your 401(k) or IRA won’t quite cover the cost of your lifestyle, an annuity might be a good idea. They come in many varieties, though, and not every type will be right for you. As such, it’s crucial to understand how they work.

What Is an Annuity?

An annuity is a financial contract that you enter into with an insurance company. You purchase the contract for a specific amount of money, either through a lump sum or periodic payments. In exchange, the insurer agrees to pay you a set amount on a recurring basis.

Depending on the type of annuity you buy, you may begin receiving payments immediately or defer them to a later date. Typically, annuity benefits are payable until your death, but some plans only allow you to receive payments for a fixed amount of time.

Types of Annuities

Annuities are not one-size-fits-all. There are several different types to choose from, and they generally fall into one of two categories: fixed and variable. A fixed annuity offers a guaranteed return of the principal you paid in, along with a minimum amount of interest. Your payments stay the same for the entire length of the contract, so you’ll know exactly how much income you can expect. Certain fixed annuities may be indexed, which means your returns are linked to a specific market index, such as the S&P 500.

Variable annuities, on the other hand, work a little differently. Generally, your principal investment is still guaranteed but your returns are not. When you invest in this type of annuity, you have the opportunity to choose your investments, and the better they perform, the higher your returns will be. Variable annuities have the best potential for growth, but they also tend to carry a higher degree of risk.

You’ll also need to choose between an immediate annuity or a deferred annuity. An immediate annuity starts paying off as soon as you make an initial investment. Deferred annuities, though, don’t pay off until later. If you are retired, an immediate annuity might make sense. Younger people gravitate towards deferred annuities as a plan for the future.

Fixed annuities are also categorized as either equity-indexed or market-value-adjusted, based on how the interest is generated.

Annuity Pros and Cons

what is an annuity

Obviously, the biggest advantage of investing in an annuity is that it guarantees you a certain amount of income on a regular basis once you retire. That’s a major plus if you’re concerned that you may not have saved enough, or that your expenses will outstrip your existing savings. Taxes on earnings aren’t payable until you begin receiving distributions, and compared to other types of retirement products, the investment risk is much lower.

The downside is that because the risk is generally lower, you may not see as much growth as you would get from investing the money directly into the market. Once you put a lump sum into the annuity, you’re bound by the contract limitations, so you can’t pull it back out if you change your mind. If you put in a huge amount of cash, there’s also the chance that you may never reach the break-even point if you don’t live long enough. Finally, the fees that go along with purchasing certain types of annuities can eat up a significant part of your earnings.

Taxation of Annuities

One of the most important things you need to consider before purchasing an annuity is how it may impact your tax situation. Generally, your earnings become taxable at your regular rate once you start making qualified withdrawals. That means you don’t get the added benefit of being able to apply the lower capital gains tax rate. If you start receiving payments before age 59 1/2, you’ll also get hit with an additional 10% early withdrawal penalty. If you see a substantial amount of growth from your annuity investment, you could find yourself shelling out more in taxes each year.

Whether or not an annuity is a good fit really depends on how much you already have saved and what your long-term retirement goals are. If you’re looking for a stable, predictable investment that offers some tax advantages, annuities generally fit the bill.

The Bottom Line

what is an annuity

An annuity is a contract with an insurance company exchanging premium payments for a regular payout. Annuities are a useful tool for generating retirement income. There are various types of annuities, each with pros and cons — the type of annuity that is right for you will depend on where you are in life and what you are looking to get out of your annuity.

Retirement Tips

  • A financial advisor can help you figure out how annuities and other investments fit into your retirement plan. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Before you get an annuity you should know how much money you’ll need in retirement and whether you’re on pace to meet your goals. Get an estimate with SmartAsset’s free retirement calculator.

Photo credit: ©iStock.com/Jirapong Manustrong, ©iStock.com/filadendron

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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