An annuity is an insurance policy you pay for in a single payment or series of payments. It requires the insurer to make a series of payments to you at regular intervals beginning either right away or at a set date in the future. While there are several different types of annuities, they are ultimately designed to help people supplement their retirement income. There are also tax advantages to be aware of for annuities. Here are three primary things you need to know about annuities.
How Annuities Work
An annuity pays out differently based on whether it is an immediate or deferred annuity. An immediate annuity is when you buy the policy in one lump sum and start receiving your payments right away. People may do this if they receive a large inheritance and want to receive it in smaller payments rather than having to manage a large lump sum. Another situation where someone may do this is if they are close to retiring. They may take a portion of their retirement savings and purchase an annuity to supplement their retirement income after they leave the workforce.
The other option, a deferred annuity, is when you purchase a policy but don’t plan to take payments until a later time. You could purchase the annuity in one lump sum or you could make regular contributions during the accumulation phase of the annuity.
Types Of Annuities
There are three different types of annuities you could choose from within the larger categories of immediate and deferred annuities: fixed, variable, and indexed.
A fixed annuity allows you to lock in a rate of earning over a long period of time, regardless of what the market does. The interest rate is set in the contract, which means the insurance company accepts the risk if the investment market does not do well. However, if the market does unusually well, the insurance company will reap the rewards. The other downside is that if you have a fixed annuity, you can lose spending power if there is significant inflation. That aside, these annuities are considered low-risk for buyers because they offer a guaranteed rate of return.
Variable annuities allow you to choose from a variety of investments, and then the rate of return is determined by the performance of those investment portfolios. The buyer takes the greatest amount of risk with this annuity; although, with that risk comes the possibility of a higher rate of return. Variable annuities are regulated by the SEC.
Indexed annuities have characteristics of both fixed and variable annuities. They offer you a guaranteed minimum return but also give you the possibility of some investment growth because the interest rate is combined with an interest rate that’s linked to a market index.
How Annuities Are Taxed
Your annuity is generally tax-deferred when you’re in the accumulation phase of your contract. You pay taxes when you start taking income from the annuity, and it’s taxed at the same rate as your regular income.
By taking time to understand the different types of annuities, you can better determine which option is the most appropriate for you and your situation. You can also determine what level of risk you are most comfortable with and choose an annuity that meets that risk level.
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