How Does an Annuity Work? Secure Your Nest Egg Until It Hatches

how does an annuity workWhen you have a Roth IRA or a 401k, you probably feel like you are doing all you can to be prepared financially for the time retirement comes around. Right? You might be, but at the same time, you may also be able to benefit from incorporating annuities into your plan of savings.The volatility in our financial markets and the disappearance of workplace pensions has put the spotlight on annuities as a solution potential for retirees.  Let’s discuss the major pros and cons of annuities plus the basic information you need before you go ahead and buy one. Here is a course entitled General Annuities that teach you the formulas of ordinary simple annuities to handle general annuities with one little step.

What Is An Annuity?

Basically, an annuity is an agreement where you make a single or multiple payments in exchange for getting a set income amount for a time period. For a long time, these have been around and are used commonly by retirees that are conservative who want to be sure that they will have regular incomes for the remainder of their lives. Even if an annuity is a method of money investment, they are actually a contract of insurance and thus are only sold by companies of insurance. You might want to check out this course entitled Annuities Due and Deferred that shows you what happens to your annuities when you make payments at the beginning of every period.

In other words, an annuity is a product of insurance that pays out income and can be used as part of your strategy for retirement. For investors, annuities are a choice that is pretty popular for those who want to get a steady stream of income when they retire. Basically the way it works is that you invest in annuities in future dates and pay yourself. The annuity income you get back can be doled out as a lump sum payment, quarterly, annually or monthly. The size of how much you end up paying will depend on various factors including how long your period of payment is. You can opt to get payment for a set number of years or for the rest of your life. The amount you receive will depend on whether you choose fixed annuities guaranteed pay out or a stream of pay outs that depend on your annuity’s performance, called variable annuities. For more information about annuities here is a course entitled Ordinary Simple Annuities: Advanced Problems that shows you annuities beyond the basics. Also, if you want to know the Present Value of Annuity Formula: Knowledge Is Money, here is an article that tells you what the smart decisions to make are, with regard to your money. It also explains what happens to your money with the passage of time.

How Do They Really Work?

Money held in deferred or immediate annuities can be invested in 3 basic ways and are either called indexed, variable or fixed.

Indexed annuities pay out return rates on your money tied to an economy’s index, such as the S&P500. This is considered a fixed and variable hybrid type since you get a guaranteed minimum payment and yet at the same time enjoy greater returns when there are broader market gains.

Variable annuities pay out variable return rates on your money. The stream of income usually has a guaranteed minimum amount, but can be increased depending on the underlying investment’s performances, which you select. This can include mutual funds or stocks, for example.

Fixed annuities pay out fixed return rates on your money. It is a predictable guaranteed stream of income no matter what is happening on the financial scene.

Basic Characteristics of Annuities

Annuities stand out alone as the only investment vehicle that grows on a basis of being tax-deferred without having to be put inside any type of retirement plan, qualified plan or IRA. Unless the contract is held in a qualified plan of retirement or IRA, there is no limit to the money amount that might be investment and the non-deductible contributions. Naturally, most carriers of annuities have proprietary amount limits that they can receive. However, this is usually around the five million dollar mark. Many contracts of annuities also contain declining schedules of surrender charts that disappear eventually after a given time period such as five or ten years. For instance, a ten year contract of fixed annuity might assess a seven per cent penalty for early withdrawal for money that you take out in the contract’s first year. Indexed or variable annuities usually levy early withdrawals similar charges. On the other hand, many contracts will let investors pull out ten to twenty per cent each year of principal with no penalties as a means of easing restrictions as long as investors are aged fifty-nine-and-a-half.

Types of Annuities

Aside from having a variety of options for investment, there are also a number of annuities to choose from. There are various classifications of annuities and these are categorized by features that include tax status, the length of time you get income, when you begin to receive income and the way you pay premiums. The variety of all options and features can make it a bit of a challenge to understand annuities. So I will break this down for you and start with the broadest categories of annuities: deferred and immediate before explaining the rest.

What is a Deferred Annuity?

One broad category of annuities is an annuity that is deferred. The way this works is when you receive income at a date in the future. You make multiple or one contribution during the saving phase of the annuity and then get income either as a lump sum during the phase of distribution or as a periodic payment. This is not unlike retirement accounts where money is set aside that you can access at a date in the future. As a matter of fact, you can own an annuity that is deferred inside of an account of retirement, such as a traditional 403(b), 401(k) and IRA.

What is an Immediate Annuity?

Immediate annuities provide—you guessed it—immediate income. At least this is the case twelve months after purchase. A big lump sum payment is plunked down by you which is also called one premium and begin getting a stream of income each month from that money. For instance, if you get a one million dollars life insurance payment after taxes and want a monthly income created from investing that money in annuities, you can see how much you would have to pay each month based on your gender and age. If you were female and forty years old, for example, an annuity of a million dollars would give you about four thousand, four hundred dollars each month currently.

What is a Non-Qualified Annuity?

Deferred annuities act a little like retirement accounts, even if you don’t own it inside of retirement accounts. Now as for the rules of either deferred or immediate accounts when you own it outside of a retirement account, that is called an annuity that is non-qualified. You will need to contribute after tax dollars when you have a non-qualified annuity. There are no contribution limits for this type so you can put in an amount as much as you’d like. Even if you pay a non-qualified annuity’s contribution taxes up front, you defer tax payments on their earnings until you take a withdrawal after the age of fifty-nine-and-a-half. Unlike annuities that are qualified held within retirement accounts, you won’t have to begin getting the distribution at any age in particular.

How Are Roth Accounts and Annuities Different?

You might notice that the Roth account rules sound similar to the rules of Annuities. Remember not to mix up these two, however. A Roth is a retirement account that is tax-free with annual contribution and annual limits. On the other hand, non-qualified annuities are not free of tax. You need to keep paying taxes on what you earn when taking the distribution. Annuities of this type may be great options if you can max out all of your retirement options that are tax-advantaged such as an IRA or a workplace retirement plan and you still have left over money to sock away when you retire.

So what I am trying to say is that deferred annuities act a bit like retirement accounts even if you don’t own it within retirement accounts. You enjoy growth with deferred taxes until you withdraw them at age fifty-nine-and-a-half. Form any kind of annuity; early withdrawals are generally subject to income taxes plus a penalty of ten per cent. There are some types of annuities that also charge penalties called a surrender charge for taking withdrawals early.

Immediate Annuity Pros

When investing in a nest egg for retirement, there are a few benefits you get from an immediate annuity. For one thing, you can’t lose a large nest egg eve if you manage it poorly. You get a lot of peace of mind knowing you have a monthly income guaranteed your entire life. You won’t have to pay a finance adviser for money management. You won’t have to spend time watching the markets or need to know anything about investments. You also won’t really have to spend too much time managing your nest egg in any way or reviewing statements of accounts. In the event you develop dementia or poor health, you won’t have to worry about money mismanagement. Until you receive income, you postpone paying investment earning taxes. When it comes to the amount you can contribute to annuities that are non-qualified, there is no annual limit. You get creditor protection since the only thing they can really access is your income each month, as the amount of the lump sum now belongs to the company of insurance.

Buying an Annuity

Contracts for annuities can be bought either outside or inside a qualified plan or IRA. Checks are written to acuity carriers in these instances. These can also be acquired via 1035 exchange where endowment policies, life insurance policies or maturing contracts in a previous policy of annuity can be moved free of tax to a policy of annuity with the company of your choice. Also, you might as well be aware that any life insurance cash value type such as universal variable insurance, universal or whole can also be changed into annuities. Hope this helps! If you want more information about annuities here is a course entitled Ordinary Simple Annuities: The Basics, which shows you how to find out future and present values of annuities as well as the size of payments.