What Is An Annuity?

Video Transcript

What's an annuity?

Quite simply, annuity is a financial tool.

And like most tools it helps you build something.

In this case, retirement income.

In a way, annuities are like power tools.

You have to charge them up first and you power up an annuity by paying premiums.

Later, the insurance company pays you back with interest tax advantaged in a single sum or regular intervals guaranteed.

Best of all, no matter how much you pay in the annuity can pay out for as long as you live.

So you may never run out of income in retirement.

No matter what happens in the market or economy.

No other financial tool can do that.

Plus in some instances, you can even set them up to pay a beneficiary.

Does an annuity have costs?

Sure but so do other financial tools and they can vary.

The good news is those costs help build the value other tools can't match such as the guarantees and the lifetime payouts.

Look an annuity may not be the only thing in your financial toolbox to help you save for the future but it's a handy way to help build your savings now and protect you against the risk of outliving them later which can put a real wrench in your retirement.

Of course this is just a high level look at annuities.

A visit with your financial adviser can help nail down the details tell them you saw it here first.

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Annuity Definition

An annuity is a financial product that provides a guaranteed income stream, typically used for retirement. It's a contract between you and an insurance company. You make either a lump-sum payment or a series of payments, and in return, the company provides regular payouts over time. 

How Annuities Work

Annuities work by allowing you to make a payment, either as a lump sum or through a series of contributions, to an insurance company in exchange for a future income stream. The insurer invests your funds during the accumulation phase, where the value of the annuity grows on a tax-deferred basis.

There are two main phases of an annuity:

1. Accumulation Period: You make payments into the annuity, and your account's value grows over time. The growth may be based on a fixed interest rate (for fixed annuities) or market performance (for variable annuities).
2. Payout Period: When your annuity starts distributing regular payments to you, either as a lump sum or through periodic payments (monthly, quarterly, or annually). The annuity payments can be structured to last for a specific period of time or your lifetime, providing you with a guaranteed income stream.

Annuities also offer options for different types of income, like fixed or variable payments, depending on the type of annuity chosen. They can be customized to meet individual retirement goals. Some annuities can also continue paying to a surviving beneficiary.

What Are the Different Types of Annuities?

Annuities come in various types, each tailored to different financial goals and investment objectives, mainly for retirement income. Here are the main types of annuity products:

1. Fixed Annuities

• How They Work: Fixed annuities provide guaranteed, regular payments for a set period or for life. The interest rate is fixed, meaning it doesn’t fluctuate with market changes.
• Best For: Individuals seeking low-risk, predictable income.

2. Variable Annuities

• How They Work: Variable annuities allow the investor to choose from various investment options, often similar to mutual funds. The payout depends on the performance of the chosen investments and market conditions, meaning payments can fluctuate.
• Best For: Individuals who are willing to take some investment risk for the potential of higher returns.

3. Indexed Annuities

• How They Work: Indexed annuities combine elements of fixed and variable annuities. The return is linked to a stock market index, like the S&P 500, but with protection against market losses. Gains are capped, but losses are limited or eliminated.
• Best For: Individuals looking for a balance between potential market gains and protection from downside risk.

4. Immediate Annuities

• How They Work: With immediate annuities, the individual pays a lump sum to the life insurance company, and the payouts begin almost immediately, typically within a year. This option is often chosen by people who are already or about to retire.
• Best For: Individuals who need immediate income, typically in retirement.

5. Deferred Annuities

• How They Work: Deferred annuities begin payments at a future date. During the deferral period, the invested money grows tax-deferred. This type is helpful for individuals still in the accumulation phase of their financial plan.
• Best For: Individuals planning for future retirement income.

6. Qualified vs. Non-Qualified Annuities

Understanding the difference between qualified and non-qualified annuities is vital when determining how to fund your annuity purchase.

• Qualified Annuities: Funded with pre-tax dollars, typically through retirement accounts like a 401(k) or IRA. Taxes are paid on both principal and earnings upon withdrawal.
• Non-Qualified Annuities: Funded with after-tax dollars, only the earnings portion is taxable upon withdrawal.

Each annuity type offers distinct benefits; the ideal choice hinges on personal financial needs, retirement goals, and risk tolerance. When choosing an annuity, it's essential to consider the associated costs, fees, expenses, and charges.

What Are the Benefits of Annuities?

Annuities offer several benefits, particularly for individuals seeking reliable, long-term income. Here are the key benefits of annuities:

Guaranteed Income

Annuities offer a dependable income stream, either for a fixed term or for life, making them an essential tool for ensuring steady cash flow during retirement.

Tax-Deferred Growth

Annuities let your premium grow tax-deferred, meaning you pay taxes on earnings only when you receive payouts, allowing your money to grow more effectively over time.

Customizable Payout Options

Annuities provide flexible payout options, including a lump sum, regular payments (monthly, quarterly, annually), or lifetime income. This customization allows you to structure the income to fit your financial needs.

Longevity Protection

Annuities, particularly lifetime annuities, protect against the risk of outliving your savings by providing income for the rest of your life, regardless of how long you live.

Principal Protection

Fixed and indexed annuities protect your principal from market downturns. Even if the market performs poorly, your original premium and returns (in the case of fixed annuities) are safeguarded.

Legacy Planning

Certain annuities let you designate beneficiaries, ensuring any remaining funds or payments can be passed on to your loved ones after your death, making them a helpful estate planning tool.

Inflation Protection

Some annuities allow inflation-adjusted payments to help maintain purchasing power, making them useful for long-term retirement planning.

No Contribution Limits

Annuities, unlike other retirement accounts, have no annual contribution limits, enabling unlimited retirement income.

Diversification of Retirement Income

Annuities can complement other retirement savings, such as Social Security, pensions, and 401(k) plans, helping provide additional financial security and diversification in your retirement portfolio.

These benefits make annuities an attractive option for individuals who want a stable, predictable income stream, protection from market volatility, and tax advantages in retirement.

How Are Annuities Taxed?

How you're taxed depends on the type of annuity:

• Qualified Annuities: Funded with pre-tax money, like contributions from a traditional IRA or 401(k). When you receive payments, the entire amount is taxed as ordinary income.
• Non-qualified Annuities: Funded with after-tax money. Only the earnings portion of your payouts is taxed as ordinary income. Since they were already taxed, your original contributions will not be taxed again.

Important points to remember:

• Withdrawals before 59 1/2: If you take money out before age 59 1/2, you'll generally face a 10% early withdrawal tax penalty on top of any taxes owed.
• Required Minimum Distributions (RMDs): Qualified annuities are subject to RMDs, meaning you must start taking withdrawals by a certain age. Non-qualified annuities generally do not have RMDs.
• Death Benefits: If you die before receiving all of your annuity payments, your beneficiaries may receive a death benefit. Depending on the type of annuity and how it is received, this benefit may be subject to income tax.

It's crucial to consult with a financial advisor or tax professional to understand an annuity's specific tax implications based on your circumstances. They can help you determine the best approach for your financial goals and minimize your tax liability.

Do Annuities Have Any Tax Advantages?

Yes, annuities offer several tax advantages. One of the primary benefits is tax-deferred growth, meaning that you don’t pay taxes on earnings until you begin receiving payouts or make withdrawals. Your annuity grows more efficiently over time in tax-deferred accounts, benefiting more from compounding and leading to greater wealth accumulation.

Non-qualified annuities have no annual contribution limits.

Bottom Line

Understanding the different types of annuities and their tax advantages, payouts, and structure can help you feel confident in preparing for your retirement needs. Many variables may be involved, but a good foundation of knowledge can help you make the best choice.

Consider contacting a financial professional if you would benefit from personalized insights and guidance based on your financial situation and retirement strategy.

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