What is an Annuity?
An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future. They offer steady income but have some downsides. Annuities come in three main varieties - fixed, variable, and indexed - each with its own level of risk and payout potential. The income you receive from an annuity is typically taxed at regular income tax rates, not long-term capital gains rates, which are usually lower.
Annuities are contractually executed, relatively low-risk investment products; the insured (usually, an individual) pays a life insurance company a lump-sum premium at the start of the contract. That money is to be paid back to the insured in fixed, incremental amounts, over some future time period (predetermined by the insured). The insurer invests the premium; the resulting profit/return on investment fund the payments received by the insured and compensate the insurer.
Conventional annuity contracts provide a predictable, guaranteed stream of future income (e.g., for retirement) until the death(s) of the beneficiaries(s) named in the contract, or, until a future termination date – whichever occurs first. These financial instruments have been used to accumulate funds and provide significant and sudden increases in personal income (via future, lump-sum withdrawals), all while legally avoiding the taxes (e.g., income-, capital gains-, estate-) that would otherwise be assessed on them.
Immediate Annuities vs. Deferred Annuities
An Immediate Annuity is an investment that turns your current retirement savings into future income payments. When you buy an immediate annuity, you receive guaranteed income payments for a set number of years - or possibly for the rest of your life. You provide an upfront investment, and the annuity company guarantees regular income for the life of the contract. This income guarantee makes annuities an attractive option for some retirement investors, but it comes with its own costs. There are fees to watch out for, and once you've purchased an annuity contract it can be expensive to withdraw your principal investment. If you needed to withdraw additional funds beyond your regular annuity payment for a given month or year, you could face high penalties.
A Deferred Annuity is an insurance contract that promises to pay you a regular income or a lump sum of money at some date in the future. You can make one-time or recurring deposits into the annuity and let them grow tax-deferred until you start receiving payments.
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