Annuities are a good investment for an investor who cannot cope with short-term volatility and/or one who has a risk tolerance that can only be described as moderate. Annuities can be an excellent form of investment and can add value to a portfolio. Here we look at an overview of annuities.
Before we go any further it is necessary to define what an annuity is. It is a contract that is made between yourself (the annuitant you are called in this case) and an insurance provider. The contract stipulates that the insurance company will pay you a specific sum of money periodically for a particular length of time.
An annuity is comparable to a form of insurance that is retirement and income based. How it works is that you, the annuitant, contribute money to the annuity and in return you are guaranteed a source of income of your choosing in the future. Annuities are not a suitable investment choice for everyone but they are very popular for many. In particular they are often bought by those individuals who want to be assured of a minimum stream of income once they finish working and settle into retirement life.
Annuities in many cases provide for the sheltering of taxes. What this means is that the monetary contributions you make to it reduce the amount of money you are taxed for that given year. That means that the earrings you make from the annuity can grow without being taxed. This all changes however once you start to draw money from the annuity. Many young people appreciate this aspect of annuities. They can contribute to a deferred annuity for many years and are able to do so without having to worry about paying taxes on the money they are building.
Annuities are a long-term retirement planning tool as opposed to a short-term investment. The vast majority of annuities penalize the annuitant if they take out money before a specified number of years have passed. The rules of the tax system also encourage investors to avoid touching their annuity earnings until they have reached a minimum agreed upon age. However as we all know, sometimes in life emergency situations call for financial assistance. Most annuities are such that the investor can withdraw anywhere from 10 to 15 percent puff the funds from the account without suffering a penalty if an emergency arises. This is useful to know when you start the annuity account.
How Annuities Work
Once you understand what an annuity is it then become imperative to understand how it works. There are two main ways that annuities are created and used. There are immediate annuities and deferred annuities. Let us explore both of these concepts now.
An immediate annuity is what happens when you contribute a lump sum of money to the annuity and then start to receive regular payments without delay. You can choose from different annuity packages. You may choose a fixed, variable or specified amount. In most cases this will last for as many years as you have to live. This kind of annuity is most commonly chosen by those who have inherited a great deal of money at once or by someone who has won money in a lottery. Immediate annuities take the sum of money and turn it into an income stream that is for life. What this means is that you will be guaranteed an income into your elderly years.
On the other hand, deferred annuities are designed differently. As an investor in an annuity you would contribute money to the annuity account and watch it grow over the years you are working. The goal is to build a large enough stream of income for when you decide to retire from your job. The contributions you make to the annuity over the years are tax sheltered until the point at which you make the decision to start withdrawing money from the annuity. The period of time that you contribute funds to your annuity account and the years it builds is referred to as the accumulation phase.
Advantages of Tax Sheltering
Being able to shelter your taxes as you grow a deferred annuity has its share of advantages. If the money you contribute to the annuity account comes by way of an IRA or something similar in nature then in many cases you are permitted to defer your taxable income on a yearly basis equal to the amount that your contributions come to. What this means is that every year that you contribute to your annuity you get the benefit of tax savings. Also worth noting is that the capital gains you make during the accumulation phase are not subject to taxes. Over the long haul the savings you make on taxes can compound and can lead to even higher returns in the future.
Another thing to bear in mind as well is that the majority of people earn less money after they retire than they do during the years that they worked. This means that upon retirement they fall into a lower tax bracket. Fewer taxes are required to be paid on your assets than what you would have paid if you had declared the income when you first earned it. This means that the return you make following your taxes is greater.
The Purpose of an Annuity
The goal of an annuity is very simple to understand. It provides the investor with a source of long-term income that is steady and stable. Once you decide to start withdrawing money from your annuity account you must let your insurance company know of your wishes. This is known as the distribution phase. Actuaries employed by the insurance provider use a mathematical model to figure out what your periodic payment amount is to be.
The current dollar value of the annuity account plays a role, as does the age you are at the present time, your life expectancy and the anticipated future inflation-adjusted returns from the annuitant’s assets. Your payments will be higher the longer you hold off withdrawing from the account. Spousal provisions also play a role in the payments you will be entitled to.
The majority of individuals who open annuity accounts make the decision to receive payments on a monthly basis for the remainder of their lives as well as the remainder of their spouse’s life. What this means is that payments do not cease until both individuals have passed away. For most people the peace of mind this provides them for the duration of their life whether they live to be 75, 80, 90 or 100 is tremendous!
Annuities- Fixed and Variable
There are two different types of annuities. There is the fixed annuity and the variable annuity. Your financial needs and goals will determine which is most suitable for you. Let us look briefly at the difference between the two.
A fixed annuity is a low risk form of investment income. As the name suggests it provides a fixed amount of money on a monthly basis as long as you live. However the lack of risk also means that there is less potential for growth. If bull market conditions prevail in the financial markets following your retirement then you will not receive additional gains on your annuity earnings.
Variable annuities are different from fixed annuities in that you have the opportunity for the appreciation of your earnings at the same time that you are drawing income from the annuity account. The insurance provider can guarantee a minimum income stream form a variable annuity through what is referred to as a guaranteed income benefit option. You are able to enjoy bigger payments when your investment portfolio shows higher returns. When the portfolio has lower returns then smaller payments will result. Many people like variable annuities because they strike a balance between a retirement income that is guaranteed and the opportunity for continued
