How Do Annuities Work?
Annuities are not as complicated as many people believe.
Understanding how annuities work is relitively straightforward.
Below we go over the essential components to help you explore whether an annuity investment is right for you.
How Do Annuities Work?
What is an annuity? An annuity is a long-term investment vehicle that can provide both financial security and has real growth potential. These unique finical products help increase your income throughout retirement and can ensure that you never outlive your money.
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According to Investor.gov, “An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments. Similarly, your payout may come either as one lump-sum payment or as a series of payments over time.”
In other words, you make premium payments to an insurance company in exchange for certain income guarantees in the future.
Accumulation of Funds – Loading Your Investment
Annuities have two phases, accumulation and distribution. These are the main two components to understanding how an annuity works.
The accumulation phase builds your investment through scheduled premium payments. Only once your investment is complete can you begin taking income distributions.
There are two ways to load your annuity.
Immediate Annuities form through a single, one-time lump-sum premium payment. In contrast, Deferred Annuities loads over time through a series of scheduled premium payments.
Deferred annuities are convenient because they allow you to load your investment over time without breaking your budget. Immediate annuities are great for those rolling over other assets such as a 401k or IRA.
Understanding Interest Rates
Your accumulated premium payments form an investment pool that grows interest over time. One of the benefits of an annuity investment is that you get to choose the interest rate in which your investment grows. Both immediate and deferred annuities offer fixed or variable interest rates.
Fixed Annuities have a guaranteed interest rate in which your money grows. Therefore, you know exactly how much retirement income your investment will produce before making your purchase. Fixed annuities offer higher yields than traditional low-risk investments such as CDs or Bonds, making them an ideal low-risk component for your retirement plan.
Variable Annuities have interest rates that fluctuate depending on market performance. These products have the potential for high returns; however, they also carry risk due to market exposure.
Distribution Phase – Scheduled Income Payments
Once you’ve successfully loaded your investment funds, you can ‘annuitize’ your investment and begin taking scheduled income payments.
As the owner, you have flexible options on how to take your income payments. There are options for a single lump sum or scheduled income payments for a defined number of years.
Most annuities provide an option that provides income payments for the rest of your life and guarantees that you never outlive your money. Lifetime income is perhaps the single biggest benefit of purchasing an annuity.
How Do Annuities Work with Taxes?
Annuities further differentiate by taxes. An annuity inside a formal retirement plan is known as a Qualified Annuity, while non-retirement annuities are designated as non-qualified.
Qualified Annuities have tax advantages that help increase your income throughout retirement. This benefit allows you to load your investment with pre-taxed funds to grow and compound interest at a faster rate. With these products, you delay your tax obligation into the future until you begin taking income distributions.
Non-Qualified Annuities are not part of a formal retirement plan and do not have any additional tax benefits. Because your investment funds have already been taxed before accumulation, you only pay taxes on your investment capital gain.
How Does An Annuity Work After Death?
Another benefit of owning an annuity is spousal protection after death. Most annuity contracts include a death provision that allows leftover funds to go directly to a named beneficiary. This benefit can ensure that your loved ones can maintain the same quality of living after you’re gone.
Exploring Your Options
Now that you’ve learned the basics about how an annuity works, you’ll want to explore your market options.
Many insurance providers offer annuity products; however, you shouldn’t just pick a carrier blindly. There are small differences between all insurance carriers that make them more or less suitable to specific populations. We strongly suggest working with one of our experienced independent agents to help you sort through and navigate to your best market offers.
Our independent agents work for YOU, not the insurance company. We help you shop and compare the best annuity companies and products side by side to help you live a successful retirement.
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