How Do Annuities Work?
Annuities It's a simple contract. You give the insurance company money. In exchange, the company promises to either pay you an interest rate on your money and your money grows like a savings account, or pay you a monthly income lasting for a period of time. Taking monthly payments is called annuitization.
You have various options when choosing annuitization. This monthly income could last for a set number of years or for the rest of your life. It may also be for the life of yourself and your spouse should you choose to do so. Most people begin receiving annuity income when they retire and continue receiving it for the rest of their life. The money you invest in an annuity grows on a tax-deferred basis. Your annuity income is taxed as normal income when you begin receiving it (though no income tax is paid on that portion of the income that represents the money you originally paid in to your annuity). Since most people receive annuity income after they retire when they may be in a lower tax bracket, they generally pay less tax on annuity income than on income they earn while working full time.
Two other important points regarding taxation:
- Whether you're in the payout or accumulation stage, any income you actually receive from an annuity is taxed as ordinary income rather than as capital gains.
- If you withdraw money prior to age 59 1/2, you may be subject to an IRS tax penalty of 10% of the accrued earnings.
How Do Annuities Differ from Life Insurance?
Annuities Life insurance pays your family cash benefits when you die. Annuities typically begin paying you an income when you retire and may continue paying you an income for as long as you live. (Most annuities stop paying money when you die; though some annuities can continue paying money to your family after your death if you select that option.)
Is An Annuity Right For Me?
In the past, annuities were considered investments only for people nearing retirement. But today, annuities can be smart investments for people of all ages. Remember, an annuity can be invested in a variety of different investment instruments, offering everything from modest to fast capital growth alternatives. The following are good uses for annuities:
- You need a higher interest-rate alternative to Certificates of Deposit (CD's) and money market funds.
- You want to make your long-term savings grow faster without current taxation.
- You need to save more for retirement, but you have "maxed out" your IRA and 401(k) or 403(b).
- You need to roll over (reinvest) existing tax-deferred savings, like pension plans.
- You need to guarantee yourself an income for the rest of your life.
- You need to guarantee yourself an income for the rest of your life and your spouse's life.
- For purchasers of a special type of annuity called an Equity Index Annuity, you want to protect your "principal" with a guaranteed rate of return while investing in the equity markets.
How Much Should I Invest?
Annuities How much money you put into an annuity depends upon your financial goals and the type of annuity you are purchasing. In general, a traditional annuity should be considered for its ability to build tax-deferred earnings from otherwise taxable investments such as mutual funds and CD's. An Equity Indexed Annuity should be purchased for participation in the stock markets while protecting principal from downside risk.
Beyond tax advantages, there are important reasons to invest in an annuity, especially when you consider the limitations of other types of investments. Annuities can provide:
- Guaranteed income -- An annuity can provide you with a guaranteed lifetime income.
- Unlimited contributions -- You can contribute an unlimited amount of money to an annuity during the year.
- Bonus rates -- Some annuities award investors with bonuses.
- No risk of loss -- Funds are not tied to stock market.
- No-penalty annual withdrawals. -- You can withdraw a certain amount per year penalty free.
- No-penalty rollovers -- Company pension or profit-sharing plan payouts may be reinvested.
- No probate in case of death -- Your family will find it easier and less costly to obtain the value of the annuity.
- Shelter investment earnings -- Retired people can use annuities to shelter investment earnings that would otherwise lead to taxation of Social Security benefits.