An annuity is a contract with an insurance company which makes a series of payments at regular intervals. Annuities are most often bought for future retirement income. Only an annuity can pay an income that can be guaranteed to last as long as you live.
An annuity is neither a life insurance nor a health insurance policy. It’s not a savings account or a savings certificate. You shouldn’t buy an annuity to reach short-term financial goals. A deferred annuity has two periods, accumulation and payout. During the accumulation period of a fixed annuity, the money invested earns interest. The earnings grow tax-deferred as long as you leave them in the annuity. The minimum guaranteed interest rate is the lowest rate your annuity will earn. During the accumulation period of a variable annuity, you direct your investment (less any applicable charges) into a separate account, similar to mutual funds. You may put your premium into a stock, bond or other account, depending on how much risk you want to take. In the second or payout period, the company pays income to you or to someone you choose.
If you need access to your money, you may be able to take all or part of the value out of your annuity at any time. If you take out the entire value and surrender or terminate the annuity, you may pay a surrender charge. The company will eliminate the surrender charge after you’ve had the contract for a stated number of years. Some annuities waive withdrawal charges in certain situations, such as confinement in a nursing home, terminal illness or death where the beneficiaries will receive the benefit of the annuity.
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Under current federal law, annuities receive special tax treatment. Income tax on annuities is deferred, which means you aren’t taxed on the interest your money earns while it stays in the annuity. Tax-deferred accumulation isn’t the same as tax-free accumulation. An advantage of tax deferral is that the tax bracket you’re in when you receive annuity income payments may be lower than the one you’re in during the accumulation period. You’ll also be earning interest on the amount you would have paid in taxes during the accumulation period. Finally, these questions may help you decide which type of annuity meets your retirement planning and financial needs. You should think about what your goals are for the money you invest into the annuity. You need to think about how much risk you’re willing to take with the money. Ask yourself:
- How much retirement income will I need in addition to what I will get from Social Security and my pension?
- Will I need that additional income only for myself or for myself and someone else?
- When will I need income payments?
- Does the annuity let me get money when I need it?
- Do I want a fixed annuity with a guaranteed interest rate and with no risk of losing the principal?
- Do I want a variable annuity with the potential for higher earnings that aren’t guaranteed offset by the possibility that I may risk losing principal?
- Or, am I somewhere in between and willing to take some limited upside potential and no risk of principal loss with an equity-indexed annuity?
Rick Althoff, CLU, ChFC holds a Masters of Financial Services and is a former professional with the Social Security Administration who now owns Financial Planning Associates in Sioux Falls. He and his wife Mary are the proud parents of ten university-educated children.