A Beginner’s Guide to Annuities

An annuity is defined as a contract where you pay an insurance company a regular premium that will then be distributed back to you over time at a later date. Since annuity contracts guarantee a set distribution of income over time, many people use annuities to fund their retirement years. However, withdrawing money early from your annuity incurs additional fees to the insurance company and tax penalties.

An annuity contract consists of two phases: a deferral phase, where you pay money into an account, and an annuity or income phase, where the insurance company sends you payments regularly. Depending on the contract, the annuity phase may last for a set amount of time, such as 10 years, or continue until the death of both you and your spouse. An annuity contract with both a deferral phase and annuity phase is called a deferred annuity, but a contract that only contains an annuity phase is considered an immediate annuity.

Deferred Annuities

In a deferred annuity, any increase in funds due to accumulation of interest is not taxed until you withdraw the increased funds; this is called tax-deferred growth.

If the deferred annuity grows only from interest earnings, then it is considered a fixed annuity. A fixed annuity’s funds can never go below what you initially invested.

If the annuity funds can be allocated to stocks or bonds, in which case the account value can fall below what you invested, then it’s called a variable annuity.

If your annuity grows at a rate that is based on an index, such as the S&P 500 Composite Stock Price Index, then you have an indexed annuity. Like a fixed annuity, this type of contract guarantees that the account value will not fall below a specified minimum regardless of how well the index performs.

Immediate annuities

In an immediate annuity, you pay an insurance company a sum of money to guarantee that they send you regular payments. In other words, you’re distributing savings back to yourself from a tax-deferred growth account. The payments occur over a set number of years or until your death, and the payment amount can be at a fixed value or increase over time. One of the most common uses for this type of annuity is for pension income during retirement.