What is ANNUITY and How does it work?

An annuity refers to a contract between an individual and an insurance company where the individual makes a lump sum payment or series of payments, and then receives regular disbursements, either immediately or at some point in the future. The income received from annuities is usually taxed at regular income tax rates and not capital gains rates. The goal of buying an annuity is to provide a steady stream of income, most especially, during retirement. 

An annuity can be designed based on the needs of the buyer; and the buyer has the right to chose when and how to annuitize his contributions, that is, commencement of payments. Immediate annuity begins paying out immediately, while deferred annuity starts at a predetermined date in the future. The buyer also has the right to chose a payment mode, that is, choosing between making a lump payment or a series of payment to the insurer. 

The duration of payments varies as well. Payments can be made for a specific period of time, such as 20 years, or for the rest of your life. 


How Annuities Work

Annuities are constructed and used by investors in two ways, they include: immediate annuities and deferred annuities. In an immediate annuity, the buyer contributes a lump sum to the annuity account and then starts receiving disbursements of either fixed or variable amounts. This annuity converts a cash pool into a lifelong stream of income. This annuity is good for jack-pot winnings or inheritance.

Deferred annuities are constructed in such a way that capital is accumulated during the working life of the individual in order for a sizeable income to built upon retirement. This regular contribution grows the annuity account and keeps the income sheltered from tax until withdrawal. The investors can also transfer large sums from another account (an example is pension plan) and subsequently follow with small periodic contributions.


Types of Annuities

There are three main varieties of annuity and they include fixed, variable, and indexed annuities. 

Fixed annuities are annuities that pay out a guaranteed amount. The insurance company gives out a fixed return on the initial investment. Fixed annuities are not regulated by SEC. Fixed annuities offer a relatively modest annual return, generally slightly higher than a CD from a bank.

Variable annuities provide an opportunity for a potentially higher return, and is, however, accompanied by greater risk. Here, the individual picks from a menu of mutual funds that goes into his or her personal "sub-account." Also, payments upon retirement are based on the performance of investments in the sub-account. This type of annuity is regulated by the SEC in the United States of America, and they allow direct investment into various funds that are specially created for variable annuities. The insurance company guarantees a certain death benefit or lifetime withdrawal benefits.

An indexed annuity is a blend of a fixed and variable annuity when it comes to risk and potential reward. Here, the buyer receives a guaranteed minimum payout, although a portion of the return is tied to the performance of a market index, such as the S&P 500 or Nasdaq


Advantages of Annuity

There are several advantages of annuity and they include:

  • provision of lifelong income;

  • taxes on deferred annuity taking effect only upon withdrawal of funds;

  • guaranteed rate of return for a fixed annuity, thus a steady stream of income.


Signing Up For Annuity

Investors can sign up for annuity on Fidelity 


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