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Breaking Down Annuities: What They Are and How They Work


What differentiates annuities from life insurance plans and pensions? Read on.

With the baby boomers set to retire and Generation X quietly shoveling money aside in anticipation of retirement, the market for annuities remains booming at $200 billion a year, according to NPR. Before ponying up a lump sum of your savings in hopes of brighter golf greens, see if an annuity is right for you with this crash course in annuity fundamentals.

What is an annuity?

In the simplest terms, a policyholder invests in the annuity in exchange for expected periodic payouts from the day you retire until you pass away. If you stay alive longer than expected, you yield greater returns on your investment.

How's it different from every other retirement tool?

Some fundamental distinctions between annuities and pensions include the fact that annuities are based on a predicted life expectancy calculated by the insurer. If you happen to outlive the predicted date, good on you, you'll also be getting more bang for your buck as annuities protect against inflation better than pensions. If that's not reason enough to buy into an annuity, insurance companies, to make annuities appealing for retirees and soon to be retirees, manipulate multiple variables in the equation to provide for a variety of annuity options.

How many variables are there?

The most basic variation on an annuity is the option of choosing between a deferred annuity and an immediate annuity. An immediate annuity should sound familiar; it operates in parallel to life insurance. In the case of life insurance, you preemptively make monthly payments for a large payout upon death. On the other hand, an annuity works in a similar but inverted manner, you pay a lump sum up front for periodic payouts until you pass. A deferred annuity is just what it sounds like: an initial lump sum contribution made with subsequent periodic payments during the accumulation phase. It is up to the policyholders to decide when to cease contributions and start payouts.

Another dichotomous variable in the world of annuities features fixed and variable rate policies. Fixed rate annuities are well suited for the risk averse as they promise a guaranteed interest rate. Fixed rate annuities can be immediate or deferred. Variable rate annuities let you play in the market a little bit. Insurers guarantee a minimum income stream, but the remainder of the payout is contingent on your managed annuity portfolio and how well those investments do.

Sometimes, variables are thrown into the annuity equation to make the package more appealing to buyers. One example is that in an old annuity product, once the policy holder passed, the remainder of the income stream would be diverted back to the company issuing the annuity. Now you can customize packages to make sure that money will be passed onto a beneficiary after death. There are even options to stipulate that if both individuals pass, the remaining guaranteed years of payment will be diverted into the estate. There are even provisions that allow you to tap into an annuity earlier than you had planned in the case of emergency situations. All of these stipulations come at a cost, with higher fees and in some cases decreased payouts over time.

What does it really cost?

If you are just in the retirement planning stage and a far ways off from actually picking up golf clubs and moving to sunnier climates, one thing on your mind ought to be the taxation rates associated with annuities. Similar to other retirement investment options, the contributions that you make towards an annuity are deducted from your taxable earnings and your investments can grow freely away from the tax man. The downside later along the line is once you start tapping into that nest egg, the income stream you're tapping into is fully taxable. On the upside though, you will be bringing in far less when you are retired so your taxes will not be nearly as high as they are while you are working.

Is it right for me?

Just like any other investment, this one necessitates a good amount of research. Firstly, figure out if an annuity is right for you, your family, and your needs. Annuity terminology and fine print can get overwhelming so take extra note of the terms explained above before heading into the office of a commission-based annuities salesperson. Check out the Security and Exchange Commission's site for further details on annuities and protecting your interests as you go forth towards retirement.

Editor's note: This story originally appeared on NerdWallet.

To read more from NerdWallet, see:

How to Find the Best REITs and Real Estate Funds

NerdWallet's Dirty Dozen: The Worst Mutual Funds

What Is A Hedge Fund: Opportunity and Diversification But Not For Everyone
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