YOU ASK:

What is an annuity?

WE ANSWER:

An annuity is a financial vehicle providing additional retirement income on a tax-deferred basis.

It is a contract between you, the annuitant (the one doing the investment), and the insurance company, bank or financial institution. The contract stipulates that you will make regular payments to the bank and in return, at an appointed time, you will receive the return for your investments as future income.

The payments can be made monthly, quarterly, semi-annually or annually. The stream of payments you stand to get in the future depend on the amount of contributions you make, the length of your payment period as well as the rate of return provided - whether fixed or variable.

Every employee can purchase an individual annuity, which will guarantee them regular financial resources, in addition to the Social Security benefits and any benefits provided by their employers' retirement plans.

There are various kinds of annuities:

  • Fixed annuity. This provides a guaranteed rate of return.
  • Variable annuity. This provides a rate of return based on the performance of the investment.

Why Purchase an Individual Annuity?

The purpose of an annuity is to provide a lifetime income, typically for retirement, that the annuitant, or the insured, cannot outlive. Therefore, anyone who wants to make sure that they have sufficient funds when they retire will benefit from purchasing an individual annuity. This is particularly valid for people whose standard of living cannot be covered by Social Security benefits alone, or whose employers do not offer any retirement plans.

How Annuities Work

An annuity works by:

  • Enabling you to save up for a later event, such as retirement.
  • Providing you with regular income throughout your lifetime (depending on how the annuity is set up).
  • Providing your beneficiaries with a payment upon your untimely death. A guaranteed period annuity provides your beneficiaries with the promised benefits even upon your death. However, this is only for a specified number of years.
  • Providing you with a vehicle that will allow you to save on a tax-deferred basis. Your investment on the annuity will not be taxed. The taxes will only be charged when it is time for you to withdraw your money, or when the scheduled annuity payments begin. This is in contrast with other investment vehicles, which are taxed yearly.
  • Protecting the investment from creditors. The law protects your annuity and creditors will not be able to touch this. What creditors can do is to access the payments at the time that they are made - and in some states, even the payments are also protected.

Differences and Similarities between Annuities and Life Insurance

Whereas life insurance provides protection against dying prematurely before the accumulation of a sufficient amount of resources, an annuity protects the annuitant against living too long and exhausting one's financial resources while one is alive. Thus, we can conclude that an annuity is the opposite to life insurance.

However, there are certain similarities between these two products. Just like life insurance policies, you can buy an annuity from a life insurance company.

Annuities also have a "life insurance" component - wherein if you die before the annuity matures, your beneficiary receives the current value of the annuity. There are guarantees wherein if the investments of the annuity do not do well so that the current value of the annuity is smaller than what you actually put in, then the beneficiaries will receive the actual amount you put in.

The other significant feature that an annuity and a life insurance policy share, is that risk is transferred from the consumer to the insurer, the only difference being that with annuities, the risk transferred is the risk of outliving one's assets.

Annuity Options

The annuitant has several options concerning the distribution and payment of the savings.

Accumulation period: the majority of annuities have a savings account, which earns interest on the principal and builds up on an annual basis. Depending on the type of annuity, the insurance company can either provide a guaranteed minimum rate of return, or a variable, non-guaranteed interest rate. In both case, the interest earned is not subject to tax.

Annuity period: it is the period when the annuitant begins receiving installment payments. The annuity period typically starts when the annuitant reaches a certain age specified in the annuity contract.

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