Before purchasing an annuity, it’s important to know the fundamentals.
Here are some helpful annuity basics to cover.
What is an Annuity?
An annuity is a contract between a policyholder and an insurance company. You make premium payments. In exchange, the insurer provides certain contractual guarantees. These guarantees cover a variety of contract components, including income, interest rates, or withdrawals. Premium payments may be a one-time lump sum or a series of payments over time.
The purpose of an annuity is to provide an annuitant with a steady retirement income stream. Except for immediate annuities, most annuities allow for tax-deferred money growth until they’re withdrawn.
In some annuity contracts there’s a second period called the payout period. During this period, the insurance company pays income to you or to someone you choose. This is also called the distribution period, which in most cases you’re able to choose how you want to distribute your annuity money. Examples include free withdrawals, annuitization, lifetime income withdrawals, or lump sum cash surrender
Immediate and Deferred Annuities
Depending on the annuity type, you start receiving income payments immediately or at some point in the future. This difference is what distinguishes the two main categories of annuities, immediate and deferred annuities:
- Immediate annuities – An immediate annuity is also known as a “single-premium immediate annuity.” With it, you make a premium payment (usually a one-time lump sum), and in exchange you begin receiving income soon thereafter. Income payments begin no later than 12 months after the initial premium payment.
- Deferred annuities – Unlike an immediate annuity, a deferred annuity starts income payments many years after the initial premium payment. A deferred annuity has two parts or periods. During the first period – the accumulation period – the money you put into the annuity, less any applicable charges, earns interest. This growth is tax deferred as long as the money is left in the annuity.
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Fixed and Variable Annuities
Two other annuity types are fixed annuities and variable annuities. Fixed annuities are insurance contracts which enable growth at a fixed, guaranteed interest rate. Once the initial growth period has passed (how long that first period is guaranteed for), the insurer may change the guaranteed rate depending on a number of factors.
Unlike fixed annuities, variable annuities provide an optional investment feature. Premium payments may be allocated into stocks, mutual funds, bonds, or other asset classes. If you receive interest credits, premiums and the interest credits are reallocated into this portfolio for further dollar growth potential. However, since money growth is tied to portfolio growth, your principal and interest are at risk of decline should the investments in which money is allocated have a negative performance.