What Is An Annuity?

By Pinyo, on May 13, 2008

Annuities are insurance products designed to help you invest for retirement and provide supplemental income during your retirement. The most common form of annuity is income annuity where the investor pays the insurance a sum of money in exchange for a series of regular payment for a period of time, up to a lifetime contract.

What are the different types of annuities?

There are two categories of annuities and each has two types:

Deferred Annuity

Deferred annuity allows you to invest for retirement on a tax deferred basis, while delaying payments of income. This allows you to contribute to your savings and let it grows faster without the burden of taxes. There are two types of deferred annuity:

1. Deferred fixed annuity allows you to save money while your investment grows with a guaranteed rate of returns.
2. Deferred variable annuity allows you to save money, but the performance fluctuate based on the performance of the underlying investments. This type of annuity provides you with a potential to earn superior returns.

Once you are ready to retire, you can convert your deferred annuity into an income annuity (also known as immediate income annuity or immediate annuity), which will provide you with a source of guaranteed lifetime income.

Some points to consider regarding deferred annuity:

• You should make the maximum allowable contributions to traditional retirement savings plan such as 401k and IRA before considering a deferred annuity.
• The IRS does not limit the amount you can contribute to a deferred annuity.
• Some annuities come with additional options, however you should consider the cost versus benefits when buying these options.
• Just like any other investment, high expenses will reduce your overall performance and long-term results.
• Be aware that if you withdraw your money too soon, you could be hit with big surrender charges.
• Like 401k and traditional IRA, you don’t have to pay taxes until you start the distribution.
• Taxable amount is taxed as ordinary income.
• Distributions made prior to age 59 and a half may be subject to a 10% IRS penalty.

Income Annuity

Income annuity allows you to convert a portion of your retirement savings, such as part of your 401k, IRA, and deferred annuity in to a source of guaranteed lifetime income stream. Essentially, you are giving the insurance company a lump sum in exchange for a stream of income until the day you die. There are two types of income annuity:

1. Fixed income annuity provides you with a guaranteed lifetime payments regardless of the stock market and the economy. Some annuity will increase payment by a certain percentage to give you a level of inflation protection.
2. Variable income annuity also provides you with a guaranteed lifetime payments. However, the amount will vary depending on the performance of the annuity. This type of income annuity has the potential to provide you with greater income compared to fixed income annuity.

Some points to consider regarding income annuity:

• Income annuity reduces the uncertainty of outliving your assets.
• It gives you a level of confidence to work with, or withdraw from, your remaining retirement savings.
• Payments from income annuity could work in conjunction with other sources, such as Social Security and pension to cover essential living expenses.

A Personal Perspective

Annuity may sound appealing, but remember that insurance companies are in the business of making money…a lot of it. In essence, you are playing the game of probability that favors the insurance company most of the time. However, I think annuities have their places and could be the right choice for some individuals.

Here are more articles about annuity:

• A Look at an Equity-Indexed Annuity at All Financial Matters
• The Financial Freedom Ratio: A Better Way To Measure Your Net Worth? at My Money Blog
• Be Careful When Your Financial Advisors Tries To Sell You An Annuity at My Investing Blog
• Lies Annuity Salesmen Tell: A Dateline Undercover Investigation at Consumerism Commentary

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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