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What Are Annuities, How Do They Work?

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Written by Troy Werner

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POSTED ON: December 22, 2020

Annuities are highly flexible financial instruments designed to turn an initial lump sum or series of installment payments into a larger nest egg for the future through investment. These payments are made to a financial institution, which then uses them to manage assets on your behalf until the annuity is fully paid out to you. […]

Annuities are highly flexible financial instruments designed to turn an initial lump sum or series of installment payments into a larger nest egg for the future through investment. These payments are made to a financial institution, which then uses them to manage assets on your behalf until the annuity is fully paid out to you. Annuities come in a variety of types and agreements, each designed to fulfill a specific purpose.

While annuities are flexible enough to fill several roles, they are most often used as a source of retirement income, tax deferral purposes, or estate planning. Do not mistake an annuity for a simple retirement account. There are different fees, tax considerations, rules regarding investment caps, and general complexities usually not found in most IRAs.

On the flipside, annuities can easily be customized, may guarantee minimum monthly payouts if you have a set retirement plan you wish to follow, and give you the option of circumventing limitations on tax-deferred investment accounts.

How Does an Annuity Compare to an IRA?

Where an individual retirement account has annual maximum distributions, there are no such caps on annuities. However, IRA contributions are tax-deductible (unless the IRA is a Roth IRA), whereas annuities are not (for the same reason as Roth IRAs).

Furthermore, the charges for withdrawing early from an annuity are typically steeper than they would be in an IRA – not only do you have to pay withdrawal tax penalties on payments received before age 59 ½, but you may have to pay a variable "surrender fee" if you withdraw money from an annuity before payouts are supposed to begin.

It's worth mentioning that annuities are rarely recommended to replace traditional IRAs or 401(k)s. Instead, annuities may serve a purpose as an additional tool for further investing in your retirement after you have capped out on your annual contributions to your other retirement instruments.

By attaching beneficiaries to an annuity, you can ensure that if the money you place in an annuity is not spent by the time you die, it is distributed among your loved ones without first passing through probate. This can save both time and associated probate costs.

The Different Types of Annuities

Because annuities are relatively flexible and determined by the contract you sign with the institution managing your investments, there are potentially dozens, if not hundreds, of minute variations. However, annuities are generally characterized as fixed or variable and immediate or deferred.

      • Fixed annuities are characterized by a set payout agreed upon in the contract. The insurance company effectively guarantees its customer a payment of value X at some point in the future and delivers on that promise by investing in safer vehicles.
      • Variable annuities are characterized by fluctuating value, wherein insurance companies can invest a little more freely. While the buyer has limited control over where investments are made, they may choose one among several preselected funds. Variable annuities represent a little more risk, and payments may either be fixed or variable as well.
      • Immediate annuities allow a buyer to receive payouts immediately after making a lump sum payment, with payouts determined by the contract. In contrast, deferred annuities are the more common kind. The buyer will either continue to make monthly payments or make a single lump sum and let the annuity accumulate value overtime before the first set of payouts.

How to Establish and Fund an Annuity

Annuities are established by financial institutions that offer them as an investment vehicle. Terms and conditions are usually negotiated with the respective institution, and you will be asked to pay administrative fees and other assorted costs throughout the annuity's lifetime.

Such costs include an annual mortality risk expense compensating the issuer for their risk in the contract and a surrender fee for early withdrawals. Annuities may be funded with your after-tax income or other retirement savings vehicles (like a traditional or Roth IRA or a 401(k)). You may usually opt for multiple payments or a single premium.

Annuities Can Lose Value

Annuities can lose value and money the same way other investment vehicles can: via inflation and market risk. On rare occasions, you may also have to deal with issuer risk; should the issuer of your annuity be in financial trouble, you may run into the risk of them not having the money to pay out your annuity.

Remember that an annuity is a financial instrument usually managed by a second party (a bank or an insurance company) on your behalf. If the annuity is not paid into and grown at a rate that outstrips inflation, you may end up with less purchasing power than you started with. However, the point of an investment vehicle like an annuity is to ensure that unused income can grow and outpace the inflation rate to begin with.

Do note that market risk represents the fact that investments are not always a safe bet, and if your annuity happens to be a passenger on a sinking ship, it will significantly lose value. Finally, note that you typically have very little to no say in how or where your money is invested, depending on the insurance company you are working with.

Considerations and a Bottom Line

Annuities present an opportunity for individuals who have capped on their annual contributions to continue to save up for retirement and ensure that any additional unused income continues to outpace inflation. Furthermore, they serve as a way to leave a nest egg for your loved ones via beneficiary designations, as any unused funds in an annuity bypass probate after death (unless no beneficiaries are listed or an estate is listed as beneficiary).

Regardless of whether the money invested in an annuity is pre-tax or after-tax, any payments made into an annuity are tax-deferred, which means you only pay taxes during withdrawals. If you decide to reinvest the income earned back into the annuity, you do not have to pay taxes on it yet. This allows you to continue to grow an annuity without reducing its value via tax payments.

Income earned through investments into an annuity made with a Roth IRA is typically tax-free, as well. Be sure to consult a tax professional for a detailed breakdown of how different types of annuities may help you defer tax payments and save more money over time.

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