What is an Annuity?

With the volatility we’ve seen in the market recently, stable and secure investments such as annuities are gaining in popularity. While this is a sound strategy, many do not understand how annuities function. This short article should clear up any confusion.

An annuity is a contract between you and an insurance company that is designed to meet retirement and other longer term financial goals.  You can make a one-time lump-sum payment or a series of payments. In return, the insurer agrees to make periodic payments to you beginning on a specified date.

Annuities offer tax-deferred asset growth. Instead, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates.  The theory being that most people will be in a lower tax bracket after they retire.  Early withdrawal, however, carries substantial surrender charges to the insurance company, as well as tax penalties.

There are two types of annuities — immediate and deferred.  Immediate annuities are fairly straight forward and easy to understand. You make a lump-sum contribution into the annuity in exchange for specified payouts that are scheduled to begin immediately. Deferred annuities require more explanation and include Fixed, Variable, and Indexed.  Fixed annuities pay you a specified rate of interest during the time that your account is growing. The periodic payouts are also a specified amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In an indexed annuity, you earn a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuities also provide that the contract value will be no less than a specified amount, regardless of index performance.

A variable annuity allows you to choose your investment strategy from a range of options, typically mutual funds. Your rate of return and the amount of the periodic payments you eventually receive will vary depending on the performance of the investment options you have selected.

Variable annuities are securities regulated by the SEC. An Indexed annuity is not a security; however, they along with Fixed annuities are regulated by the State Department of Insurance.


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