How Annuities Work

An annuity is actually a contract between an individual and an insurance company. Under the terms of the contract the company that issues the annuity agrees to make a regular payment to a beneficiary or annuitant. The insurance company is obligated to make this payment as long as the contract is in force.

To set up this arrangement a person will have to purchase the annuity from the insurance company. This can be done in one of two ways: if the plan is purchased in one lump sum it is called an immediate annuity. An immediate plan starts making payments to annuitant immediately. If the plan is purchased over a period of time with a number of different payments it is called a deferred annuity. Deferred annuities are often used as retirement savings vehicles. There is also something called a split annuity to which persons can contribute funds while receiving payments.

Annuities and Insurance

Even though they are issued by insurance companies and often come with insurance benefits, annuities are not insurance. Instead they are an insured investment which means they are guaranteed by the insurance company. There is even a product called a life or lifetime annuity which can provide an individual with a regular income for the rest of his or her life.

Annuities are insured by both insurance companies and state governments. A policy issued by a top rated insurance company should be a reliable source of income for years to come. Most states also insure annuities for up to $100,000 and some for up to $500,000.

Many annuities do come with a life insurance policy as part of the plan. This is an added benefit and not the primary reason for purchasing such a policy.

Guaranteed Income and Tax Deferment

The reason people purchase annuities is an obvious one they provide a guaranteed source of income. A lot of people purchase these products when they retire because they provide an additional source of retirement income. Somebody who relies on a pension and Social Security might buy one to augment those sources of money. Other persons might buy a plan to provide an income for a disabled relative.

Annuities are tax deferred which means funds invested in one are not subject to income tax until they are taken out. Unfortunately the IRS regards annuities as retirement plans so most people will have to pay a 10% tax penalty if they withdraw funds from one before age 59½. One reason why many people purchase annuities is that there is no limit to the amount of tax deferred money a person can keep in them.

Drawbacks to Annuities

There are some drawbacks to annuities that investors should be aware of. Many plans will charge fees for early withdrawal of funds and maintenance fees. These fees can be avoided by carefully reading the prospectus that comes with the plan. Unlike traditional retirement accounts there can be limits on what is taken out without a penalty.

Another drawback is inflation many annuities pay out at a flat rate and earn a low interest rate. That means inflation can quickly undermine the value of a benefit. To counter inflation investment advisors often advise the purchase of variable and indexed annuities which are designed to beat inflation. The funds in these plans are partially invested in stocks or other equities so they should deliver a higher rate of return. They can be vulnerable to market losses though. Indexed annuities are based on indexes of stock and can come with a guaranteed rate of return that can lock in market gains.