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Do you know how an annuity works? Understanding how they work is the first step in deciding if they are right for you.
An annuity is a type of investment that grows on a tax-deferred basis. Tax-deferred means you don't have to pay taxes on your earnings until you actually use the money. An annuity is a contract between you and an insurance company to either accumulate money or create an immediate income stream. The type of annuity that creates an income stream right away is called an immediate annuity, and the type that helps you accumulate money for future income is a deferred annuity.
An immediate annuity pays you monthly for either a fixed number of years or your lifetime, depending on the distribution option you choose. An immediate annuity may be appropriate for an individual who is retired, or nearing retirement, and wants to invest a sum of money to generate immediate tax-deferred returns and receive a monthly check over a long retirement period.
A deferred annuity is generally more appropriate for the investor that is several years away from retirement, wants to earn tax-deferred interest, and is already contributing the maximum amount allowed in a 401(k) and IRA account.
A deferred annuity has two phases. The first is commonly referred to as the accumulation phase or the period when you make contributions and earnings are recorded. The second phase begins when you start to access those funds. This is the distribution phase. Distribution can occur in three basic forms:
Annuitizing means you convert your annuity into a regular income stream for life.
Fixed annuities offer a guaranteed rate of interest over a specified time, or term of the annuity. Because of their fixed rates, this type of annuity can offer safety from market or interest rate fluctuations. You are guaranteed how much future income you can expect from your investment, versus the variable annuity that is tied to the market and subject to the same risks as stock and bond investments.
A variable annuity generates variable rates of return because its funds are invested in stocks and bonds. Keep in mind that neither your principal nor your rate of return is guaranteed, so the risk of a variable annuity is much higher. As with other investment alternatives, the higher the risk involved in the portfolio, the higher the potential return will be on the investment.
An annuity may be a good investment consideration if you are currently in a high-income tax bracket, are looking for a long-term investment, and have a sizable sum of money to invest. Another helpful explanation of annuities is the Navy Mutual Aid Association's Annuity Tutorial. As with any investment product, you'll want to carefully evaluate the pros and cons before making a decision.
There are similarities and differences when comparing annuities to other retirement products, such as IRA's. For example, like a traditional IRA, you don't pay taxes on the investment earnings until you begin to access the money. However, annuities can be purchased with after-tax dollars, so you pay taxes on your invested money or principal when you buy the annuity, not after you begin to receive payments. Record keeping on this type of annuity is critical to ensure you don't pay taxes twice on the principal distributions. You can also use tax-deferred investments to buy an annuity, such as 401(k) distributions. In this case, you would pay taxes on the principal at distribution since you didn't pay the taxes while you were contributing to the 401(k) plan.
Check with your life insurance company for more information about annuities and the types of annuity products available that may meet your investment goals. You should also consider the merits of other long-term retirement investments, as you evaluate your retirement needs. For more information on retirement planning, read the related articles listed in the Knowledge Center Library.
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