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What is an Annuity and How does it Work?

What is an Annuity and How does it Work
Source: sxc.hu Photo: forwardcom

Thanks to the recent stock market crash, and the subsequent losses many have seen in their retirement plans, annuities are gaining in popularity. Annuities are complex, with many subtleties and it can be difficult to figure out exactly what you are being promised. You will want to visit with a financial professional to review whether an annuity is the right decision for you. Look for someone whose income does not depend on selling annuities. We outline below some basics about what is an annuity and how it works so you have a good idea.

Let’s define annuities

An annuity is a type of investment in which you contract to put in payments for a certain amount of time, or pay one large amount of money. In return, you will receive payments at regular intervals sometime later down the road. Usually, these annuities are obtained through insurance companies. Your contribution is then invested in sub-accounts — usually consisting of stocks and bonds — that generate income for the insurance company (and sometimes for you as well, depending on how the contract is structured).

In most cases, annuities are used as retirement vehicles. There may even be penalties if you withdraw money from your annuity before you reach a certain age. Many annuities feature a regular payout that is not affected by market fluctuations. As a result, many folks are taking their retirement plans and putting them into annuities; they are worried that a market crash could wipe them out. An annuity provides stability, as long as the insurance company issuing the annuity remains viable.

There are two main kinds of annuity:

  1. Fixed
  2. Variable

As you might guess, the fixed annuity offers a payout that is guaranteed,. It may be a set dollar amount or a set percentage of the assets in the annuity. These types of annuities generally pay a rather low rate of return, since they are considered relatively safe.

Variable annuities, on the other hand, offer a possibility of higher returns (though they are still considered low-yielding investments). With a variable annuity, the rate of return varies, and you can boost your returns. However, it is important to be careful with these since, unlike with a fixed annuity, your principal is not guaranteed.

There are also hybrid annuities that combine aspects of fixed and variable annuities. There are some annuities that guarantee that you can withdraw a certain percentage of your initial account value while you live, while at the same time offering the potential for growth with a variable rate of return.

One option is an immediate annuity, in which you turn over a large amount of money in exchange for receiving immediate payouts that last for life. You might turn over $150,000 to $200,000, and be guaranteed $850 to $1,500 a month. The actual payments will depend on factors such as your age, and whether or not you have a spouse that would continue receiving payments after you pass. The older you are when you purchase an immediate annuity, the higher the payout.

Drawbacks to investing in annuities

As with all investments, there are drawbacks to annuities. One of the biggest drawbacks has to do with the fees. Even though your account may earn some returns, the fees generally protect the insurance company from having to increase your regular income payout. The fees associated with annuities can be large.

Annuities are also complex. Some of them are so convoluted that you may not actually be sure what is truly guaranteed. This has led to some fairly unpleasant surprises for some retirees. And, of course, you have to worry about whether or not you get your money’s worth. With a lifetime payout, you are guaranteed steady income until you die, but if you die soon after you begin receiving payments, you won’t get out what you put in (not that you’ll be around to really notice).

Favorable tax treatment – consider it part of your asset allocation strategy

One of the upsides to annuities is the fact that many of them (especially those intended for retirement purposes) are tax deferred. This means that you don’t pay taxes on the gains until you actually start withdrawing money. Your withdrawals, though, are taxed as regular income. So it is important to carefully plan out how much to take out, and what it means for your tax bracket.

Another consideration is the estate taxes your heirs will have to pay. An annuity pays out a death benefit that is equivalent either to the current value of the annuity, or the amount that the buyer has put into it (whichever is higher). If you die during the accumulation phase, which is while you are paying money into the annuity, the heirs just get that amount. However, the annuity amount paid to your heirs will be subject to double taxation: Regular income taxes and estate taxes.

Bottom line – Should you invest in one and when?

Like so many other investments and personal finance decisions, whether an annuity works for you is subject to your individual needs and goals. You may want to put a small portion of your retirement portfolio into an immediate annuity if a steady cash flow to cover your basic necessities is desired. In most cases, working through the twists and turns may not be worth the low returns you get.

It is also important to note that annuities can be an integral part of your asset allocation strategy, tax plans and estate plans. It is best to consult with a financial advisor who is familiar with your particular situation.

Disclaimer: I am not an investment professional. This should not be construed as investment advice. All investment carries the risk of loss. Before investing, do your own research and/or consult with an investment professional.

12 Responses to What is an Annuity and How does it Work?

  1. There are 2 more important points about annuities. A close family member recently got one and the important details were not disclosed until it was too late.

    1. You can’t get the money for years and years. In my family member’s case, the money is locked away for 15 years. It takes that long to get the money back. With an IRA, you can take the money out any time you want, subject to penalties and taxes.

    2. What if the company goes bankrupt? If the annuity company goes bankrupt, the entire account will disappear. Financial advisors say that won’t happen, but I wouldn’t trust them. How many financial institutions that were considered safe went bankrupt last year?

  2. i recently read benjamin grahams the intelligent investor and he seems to have qualms on the money making potential of these investments. also robert kiyosaki insists that they are not good investments in his latest book. i am inclined to take their advice as the gospel truth since they have been investing for a longer time than me

  3. Thanks for weighing in! I don’t know that I’d go with an annuity, unless it was an immediate one. And then I’d be very, very careful. There are so many ways to be trapped by the legalese…

  4. An immediate annuity can be a wonderful investment for a retiree looking for a guaranteed income stream. With the demise of pensions, people are having to manage their own money well into retirement. The immediate annuity can be a godsend for many people.

  5. My question is on taxes. I have heard if you take the annuity not all of it is taxed as you have invested your pension dollars to fund part of it. Is this true and if so how do they figure how much of the annuity you will be taxed on.

  6. It depends on the company that’s doing the annuity I work for a broker and we have an annuity that garanties the principle from loosing and has the up side of the market.so there is no risk involve.

      • Janny, while we wait for Eric to reply, I just want to add that it is not possible to guarantee the principal and give the FULL upside of the market. This sounds like some sort of an insurance product in which case there will be not insignificant fees to contend with. Eric might be talking about Principal Protected Notes http://en.wikipedia.org/wiki/Principal_protected_note, which generally have lower liquidity and less or no visibility in what assets are being held and opaque fee structure. Even with all the guarantees in the world it is still possible to lose principal with these instruments and you really need to evaluate if the financial institution that is selling these notes is strong enough to stand behind their guarantees.

        If you might recall, among many things that happened in the meltdown of 2008 was the total failure of the Auction Rate Securities market. Although not the same product as the PPN above, these securities were marketed to investors as safe and a way to get higher return than other fixed income securities. This market has collapsed and will never recover in the same form.

        When investing if something sounds too good to be true, it is.

  7. What happens to an annuity once the owner passes away? My Mother recently passed and she was the finance person between her and my Dad. Bank rep now contacting my 78 year old Dad trying to sell him an annuity. Is there any point to this product for a person this age? And if he passes in say the next 5-10 years what happens to the annuity? This is not money my Dad needs to live on. His bills are few and are covered by his pension and social security. This is just money my Mom left thats just sitting in a bank account.

    • If your dad has enough money, and is comfortable with his position, there isn’t much of a reason to get him an annuity at this point — in my opinion. However, I am not a financial professional, so you might get a second opinion. As far as what happens with your mom’s annuity, you will need to see what the terms of it are. Does it pass to beneficiaries? If there is a beneficiary named, then that is who should get access to the money, receiving the payments or the lump sum (again, depending on the terms of the annuity). You will need to consult with a tax professional to find out what sort of issues might arise there. If there is no beneficiary named, probate might be your course if you want the money. A financial professional you can trust (one who isn’t being compensated according to what he or she sells you) could be consulted to help you work through the complexities. Annuities can be very convoluted, and someone familiar with them can probably help you best.

  8. Question:How ie an annuity treated if you have to go into a n assisted living facility and Social Security is insufficient to pay expenses. Doyou have to invade or use the annuitysourcebefore you get other govt sources?

  9. I read the above article and the associated responses. In my case, I have two variable annuities with guaranteed lifetime income riders. I set up one of the annuities shortly after my 51st birthday. I set up the other annuity just over 1 1/2 years ago. I now am age 56. (I will be age 57 early next year.) The two insurance companies where I have the annuities have been in business for numerous decades and have very high ratings. I also am in excellent health. I will start to take distributions from the older annuity a few months after my 61st birthday. I will start to take distributions from the newer annuity shortly after my 65th birthday. In my case, having the two annuities has been an excellent idea. I have had some relatives on both my Mom’s and Dad’s side of the family who lived well into their 90’s. Furthermore, unlike most of my family members, I never smoked cigarettes, I have a good and sensible diet, and I walk about four miles a day.

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