Annuities are term deposits with insurance companies. They are similar to certificates of deposits at the bank (note: bank deposits are FDIC insured while the issuing insurance company guarantees annuities). There are two types of annuities: fixed and variable.
Fixed Annuities Explained
Fixed annuities have these general features:
• Your principal is guaranteed by the claims-paying ability of the insurance company; it will never decline.
• The insurance company adds interest to your deposit each year.
• The annuity is for a specific term that you select. Generally, the longer the term, the higher the interest.
• All interest is tax deferred (you do not report it on your tax return) until withdrawn.
• You may withdraw 10% of your balance annually.
• If you withdraw more than 10% during the term, you will pay withdrawal penalties (called surrender charges).
Most fixed annuities offer an initial one-year rate and then the rate changes each year. A few companies offer a locked-in rate for the entire period (called multi-year gaurantee annuities).
Another type of annuity is called a variable annuity.
Variable Annuities Explained
With this type of annuity, rather than receiving interest from the insurance company, your money is invested in mutual funds. You may earn more or you could lose principal, depending on the mutual funds you select.
Maybe the best choice is an index annuity.
Index Annuities Explained
In this type of annuity, your principal is guaranteed, like the fixed annuity, but your interest each year is based on increases in the S&P 500 Index. So, your interest is tied to the performance of the stock market but you can never lose your principal. You get the guarantee of a fixed annuity, with the potential profit of a variable annuity.
Everything described up until this point describes the growth phase (called the accumulation phase) of the annuity. To see how much you'll have at the end of the accumulation pahse, you can use a fixed annuity calculator.
When and how do you get your money out? At the end of the term, you have three options:
You can leave the annuity alone and continue to let it grow.
You can exchange the annuity to another company that may pay you a higher rate.
You can start to make withdrawals.
The withdrawal phase is called the distribution phase. You have three options:
You may withdraw all of your money at once
You can withdraw some money each year based on your desires
You can annuitize the policy.
'Annuitizing' means that you accept fixed monthly payments from the annuity company. The payments can span your lifetime or be limited to a specified period (e.g. 10 years). At the end of the period you select, the annuity is completely paid out. If you select a lifetime payout, the payments will continue for as long as you live.
As you might imagine, the monthly payments are usually more for a fixed 10-year payout than if you select a lifetime payout (the option, which pays the most, depends on your age).
Annuitizing may or may not be a good deal and will depend on your circumstances.
If you are single and need to maximize your monthly income, the lifetime payments may be a very good deal. On the other hand, if you want to leave money to your heirs, annuitizing would not be good because there will be nothing left at the end of the annuitization period.
Immediate Annuities Explained
An immediate annuity has no accumulation phase. It is for supplemental retirement income and almost like receiving a 2nd social security check. You make a deposit with the insurance company and immediately begin receiving payments. These annuities are generally suited for senior investors (age 70 plus) who desire to increase their monthly income.