What Is an Annuity and How Does It Work?
In its simplest form, an annuity is an agreement in which you make one or multiple payments in exchange for receiving a set amount of income for a period of time. They’ve been around for a long time and are commonly used by conservative retirees who want to make sure that they’ll have a regular income for the rest of their lives. Even though annuities are a way to invest money, they’re actually an insurance contract and therefore are only sold by insurance companies.
How Do Annuities Work?
Money that’s held in an immediate or a deferred annuity can be invested in three basic ways and are either called fixed, variable, or indexed:
A fixed annuity pays out a fixed rate of return on your money. It’s a guaranteed, predictable income stream, no matter what’s going on in the financial markets.
A variable annuity pays out a variable rate of return on your money. The income stream usually has a minimum guaranteed amount, but can increase depending on the performance of the underlying investments that you select, such as stocks or mutual funds, for instance.
An indexed annuity pays out a rate of return on your money that’s tied to an economic index, such as the S&P 500. It’s considered a hybrid of the fixed and variable types because you receive a minimum guaranteed payment, but can also enjoy a higher return when there are gains in the broader market.
What Are the Different Kinds of Annuities?
In addition to annuities having different investment options, there are also a number of different kinds of annuities. Annuities are classified in a variety of ways and are segmented by features such as:
- the way you pay premiums;
- when you start receiving income;
- the length time you receive income; and
- tax status.
The variety of all the features and options can make understanding annuities a little challenging; but we’re going to make it easy. The two broadest annuity categories are immediate and deferred.
What Is an Immediate Annuity?
An immediate annuity provides income right away—or at least within a year after you buy it. You plunk down a big lump sum payment, which is also called a single premium, and start receiving an income stream from that money each month. For example, let’s say you receive a life insurance payment of one million dollars after taxes and you want to create a monthly income from investing that money in an annuity. At immediateannuities.com you can see what your monthly payment would be based on your age and gender. If you were a 40-year-old female, for instance, a one million dollar annuity would give you about $4,400 a month right now.
What Is a Deferred Annuity?
The other broad category of annuities is a deferred annuity, where you receive income at a future date. You make one or multiple contributions during the annuity’s “savings phase” and then receive income either as periodic payments or as a lump sum during the “distribution phase.” So it’s similar to a retirement account where you set aside money that you access in the future. In fact, you can own a deferred annuity inside of a retirement account, such as a traditional IRA, 401(k), or 403(b).
Get Financial Advice About Annuities
There’s a lot more to consider when it comes to annuities, such as taxes and estate planning, so please contact us today about whether buying an annuity fits into your long-term financial strategy.