An Overview Of Annuities
Most investors share the same goal of long-term wealth accumulation. Some of us have no problem watching our investments bounce up and down from day to day, while risk-averse investors or those nearing retirement generally can’t withstand short-term volatility within their portfolios. If you are this type of investor – or one who has a moderate risk tolerance – annuities can be a valuable investment tool.
An annuity is a contract between you – the annuitant – and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: you contribute funds to the annuity in exchange for the guaranteed income stream of your choosing later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years.
Most annuities offer tax sheltering, meaning your contributions reduce your taxable earnings for the current year, and your investment earnings grow tax-free until you begin to draw an income from them. This feature can be very attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments.
Because they are a long-term, retirement planning instrument, most annuities have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10-15% of the account to be withdrawn for emergency purposes without penalty.
How They Work
Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.
With an immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be a specified, fixed amount or variable depending upon your choice of annuity package and usually last for the rest of your life. Typically, you would choose this type of annuity if you have experienced a one-time payment of a large amount of capital, such as lottery winnings or inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age.
Deferred annuities are structured to meet a different type of investor need – to contribute and accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase.
Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions.
Perks of Tax Deferral
It is important to note the benefits of tax sheltering during the accumulation phase of a deferred annuity. If you contribute funds to the annuity through an IRA or similar type of account, you are usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Also, any capital gains you realize in the annuity account over the life of the accumulation phase are not taxable. Over a long period of time, your tax savings can compound and result in substantially boosted returns.
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Annuities offer tax-sheltered growth, which can result in significant long-term returns for you if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity’s guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Finally, variable annuities allow less risk-averse retirees prolonged exposure to the financial mark