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Annuities > Basics

Annuities provide security for retirement and consist of two phases: the accumulation phase and the annuitization phase. The accumulation phase allows you to deposit money with an insurance or investment company over a period of time or in a lump sum, and it earns a rate of return. When in the annuitization phase, you receive regular payments from your insurance company until your death.

If you die before you annuitize, a death benefit provides your beneficiary with either the current value of your annuity or the amount you have paid into it, whichever is greater. For example, if you die when your investments are performing poorly, and your account value is less than what you have paid into it, your beneficiary would receive the amount you paid in.

This death benefit is no longer in place once you begin to receive payments. So even if you’ve only received payments for two years, the insurance company keeps the rest of the money in your contract. However, you can buy term certain annuities, which guarantee that either you or your beneficiary will receive payments for a certain period of time, such as 10 to 15 years. If you died three years after you began receiving payments from a 10-year term certain annuity, your beneficiary would continue receiving payments for the following seven years.

The money in your annuity is tax-deferred; it is not taxable until you begin to receive payments, which are taxed at your regular income tax rate. If you die before you annuitize, your beneficiary pays taxes on the death benefit at his or her regular income tax rate.

If you are 55 or older, annuities may be for you. Annuities are less attractive to younger investors because there is a 10 percent penalty tax if you withdraw money from your annuity before age 59½.

Ideally, you have already contributed the maximum amount to your existing tax-deferred retirement plan (e.g. 401(k), 403(b), or IRA). This is because you are already building up tax-deferred money in those plans, and the fees associated with them are usually much lower than those of annuities.

Three types of annuities

There are three kinds of annuities and each differs in how the money in your contract is invested.
  • Fixed annuity. The least risky of the three options, fixed annuities allow you to earn a fixed rate of interest that is guaranteed by the insurance company. But, if the stock market is performing well, you could miss out on larger gains. When you annuitize, your payments are also fixed.
  • Variable annuity. The annuity with the highest risk, variable annuities place your money in investment options known as sub-accounts, which are similar to mutual funds. Each sub-account has its own degree of risk, ranging from aggressive growth funds to bond funds. The opportunity for larger gains can be quite high, depending on the performance of your investment. But you run the risk of losing money if your investments perform poorly. It may also cost you to transfer your money between sub-accounts.
    When you annuitize, your payments fluctuate depending on the performance of your investments, though some variable annuities allow fixed annuitization. The insurance or investment company recalculates your payments each year based on the performance of your investments.
  • Equity-indexed annuity. Striking a balance between fixed and variable annuities is achieved with equity-invested annuities. Your money is invested in a fixed account and you can earn additional interest based on the performance of a particular stock index, such as the S&P 500, Dow Jones, Nasdaq, or Russell 2000. Here you are getting the low risk of a fixed annuity and the potential of higher gains of a variable annuity account. But the gains you may make due to the performance of the stock index are fairly low, and you essentially still have a fixed annuity. During the annuitization phase, your payments will be fixed.
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