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Annuities: What is Annuity & How They Work?

What is an Annuity
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Are you considering using an annuity? You must understand what this form of investment is first, or else you won't use this tax-advantaged option to its full potential. How do they work?

An annuity is a long-term investment issued by insurance companies. It covers you when you know you'll outlive your savings and income. Annuities are best for those who don't receive enough pension or Social Security to cover their living expenses, but those with reliable income won't need it.

Overall, an annuity offers a steady source of income for those in retirement. You can choose between receiving a lump sum or many smaller payments. If you need to learn more about how annuities work, everything you need to know is in this article.

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Insurance Companies Issue Annuities

An insurance company offers you money through an annuity contract, and it is a form of an investment contract. You take out an annuity when you need a reliable source of income during your retirement. 

The main goal is to have a consistent income for the rest of your life.

You sign an annuity contract with an insurance company, who then agrees to take your longevity risk. You receive guaranteed income in exchange for paying premiums, but your agreement will detail all of this. 

Additionally, these funds are tax-deferred, but you need to be over 59 ½ years old to receive the funds without any penalties.

Finally, you can customize your contract. You'll have the option of choosing between receiving lump-sum or monthly payments from the insurance company. You also can select when you want the payments to start.

3 Types of Annuities

There are three types of annuities for you to consider, which all have varying levels of risk and income. The main annuities include:

  • Fixed: These annuity types pay a specified amount. You can receive your funds now, through an immediate annuity, or later, through a deferred annuity. 
  • Variable: This kind of annuity offers a higher return, although the level of risk is higher. You choose from mutual funds the insurance company offers, which impacts the payments you receive. The better the mutual funds' investments perform, the more money you receive for retirement.
  • Indexed: Indexed annuities aren't as risky as variable annuities but are riskier than fixed annuities. You rely on a market index's performance to receive the funds. However, you are still guaranteed a minimum amount from the insurance company.

Overall, you'll want to choose an option with a level of risk that you're comfortable with while still receiving enough funds for retirement. It's worth noting that the fixed annuity comes with fewer fees than the other two types while being easier for many people to understand.

How Are Annuities Taxed?

Your annuity disbursements are taxed as income, and the funds receive regular income tax rates. Plus, the money you add to the annuity can't lower your taxable income. 

For this reason, many people don't buy annuities until they've reached the maximum on their other retirement accounts. In other words, it's best to consider annuities as a second option or backup plan.

How Does an Annuity Work?

An annuity works by converting a lump-sum premium into consistent payments that you receive for the rest of your life. It's an excellent option for those who require more than Social Security and their savings to pay for essentials after retirement.

The terms for everyone's annuity contract are different. 

If you purchase a deferred annuity, you pay the premium upfront to the insurance company. Then, that investment grows, tax-deferred, for the time you agreed upon in your contract. Once that time passes, you start receiving regular payments from the insurance company.

The company charges you fees for longevity and market risk, as well as managing your investment. However, you receive reliable protection from outliving the investment. Keep in mind that you won't be able to withdraw without penalties until the time agreed upon in your contract has passed.

For immediate annuities, you start receiving the funds right away. Many retirees use this option to supplement their Social Security and retirement savings.

This quick video breaks down what an annuity is and how it works:

When to Use an Annuity

You can use an annuity when you need to add more to your retirement income. Depending on your financial goals, many younger people can also benefit from purchasing an annuity. 

These are some of the reasons people use annuities: 

  • They provide an inheritance for the family.
  • They offer financial security.
  • They have tax-deferred growth.
  • They resist inflation in the long term.

There are many different cases when you would consider using an annuity. 

If you want practical advice, you should read Unlocking the Annuity Mystery: Practical Advice For Every Advisor by Scott Stolz on Amazon.com. It offers both the pros and cons of annuities in easy-to-understand terms.

Why Should You Use an Annuity?

Why you should use an annuity is that you can save money without having to pay taxes or interest now. Annuities also allow you to invest as much money as you want, as they don't have a contribution limit.

That makes them useful for those who capped their IRA or 401(k) for the year.  Additionally, annuities provide people with a sense of peace. 

You won't need to worry about funding your retirement since you'll receive a consistent income from the annuity payouts. Many people appreciate knowing they can't outlive their income.

Overall, annuities have many benefits for those about to retire. However, you might also use one as a younger person if you recently came into a lot of money and want to ensure it's taken care of properly.

Summary

Annuities are investment contracts that offer stable income after you pay the lump-sum premium. Many people close to retirement consider this option to supplement their retirement savings and Social Security payments. 

It provides peace of mind since you know you'll never run out of income.

If you're going to retire soon, annuities may also be a good option for you. Make sure you consider when you'll need the payments and how you want to invest. You can create a contract that suits all of your financial needs, so don't hesitate to ask the insurance company questions.

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