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Learn About Annuities

Annuities can be an excellent addition to any insurance plan, especially for providing additional income after retirement. Whether you're looking to get up-to-speed on the basics of annuities or want to learn how to use annuities as part of your insurance strategy, you have come to the place to get the answers you're looking for.

An annuity is a contract between you (the purchaser, or owner) and an insurance company. In its simplest form, you pay money to an annuity issuer, allocate your money to either fixed or variable investment options, and then the issuer pays out the principal and earnings back to you or to a named beneficiary. Life insurance companies first developed annuities to provide income to individuals during retirement years.

One of the attractive aspects to an annuity is that the earnings on an annuity (i.e., the interest and/or capital gains earned on your money by the issuer) are tax deferred until payments are received from the annuity issuer. In this respect, then, an annuity is similar to a qualified retirement plan. Over a long period of time, your investment in an annuity can grow substantially larger than if you had invested money in a comparable, taxable investment. However, like a qualified retirement plan, there may be a 10 percent tax penalty if you begin withdrawals from an annuity before the age of 59½.

Four parties to an annuity

There are four parties to an annuity: the annuity issuer, the owner, the annuitant, and the beneficiary. The annuity issuer is the company (e.g., an insurance company) that issues the annuity. The owner is the individual who buys the annuity from the annuity issuer and makes the contributions to the annuity. The annuitant is the individual whose life will be used as the measuring life for determining the distribution benefits that will be paid out. The owner and the annuitant are usually the same person, but they do not have to be. Finally the beneficiary is the person who receives a death benefit from the annuity upon the death of the contract owner.

Two distinct phases to annuities

There are two distinct phases to an annuity: (1) the accumulation (or investment phase), and (2) the distribution phase.

The accumulation (or investment) phase is the time period when you add money to the annuity. You can purchase the annuity in one lump sum (called a single payment annuity), or you can add a series of payments in an annuity. The payments may be of equal size over a number of years (e.g., $5,000 per year for ten years), or they may consist of a series of variable payments.

The distribution phase is when you begin receiving distributions from the annuity. You have two general options for receiving distributions from your annuity. Option 1: You can withdraw all of the money in the annuity (both the principal and the earnings) in one lump sum, or you can withdraw the money over a period of time.

Option 2: You will receive a guaranteed income stream from the annuity. This option is commonly referred to as the guaranteed income (or annuitization) option. Under this option, the annuity issuer promises to pay you an amount of money on a periodic basis (monthly, quarterly, yearly, etc.). You can elect to receive either a fixed amount for each payment period (called a fixed annuity payout) or a variable amount for each period (called a variable annuity payout). You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specified time period (e.g., ten years). You can also elect to receive the annuity payments over your lifetime and the lifetime of another person (called a "joint and survivor annuity"). The amount you receive for each payment period will depend on how much money you have in the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin the annuitization phase. The length of the distribution period will also affect how much you receive. If you are 65 years old and elect to receive annuity distributions over your entire lifetime, the amount you will receive with each payment will be less than if you had elected to receive annuity distributions over five years.

So, when is an annuity appropriate?

It is important to understand that annuities can be an excellent tool if you use them properly. Annuities are not right for everyone.

Annuity contributions are not tax-deductible. That's why most experts advise funding other retirement plans first. However, if you have already contributed the maximum allowable amount to other available retirement plans, an annuity can be an excellent choice. There is no limit to how much you can invest in an annuity, and like other retirement plans, the funds are allowed to grow tax-deferred until you begin taking distributions.

Annuities are designed to be very long-term investment vehicles. In most cases, you'll pay a penalty for early withdrawals. As long as you're sure you won't need the money until at least age 59½, an annuity is worth considering. If your needs are more short-term, you should explore other options.

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