The concept of receiving a steady stream of income for a period or indefinitely for the rest of your life sounds ideal. And it is what many investors try to achieve through their investment efforts. For example, some purchase rental real estate to enjoy regular rental income, and others purchase dividend-producing stocks. While these are top options to consider, some investors are choosing to invest in annuities. That is due to the many unique benefits they provide. By asking what is an annuity, you may be able to determine that this is the right investment option for you.
The Concept of an Annuity
When many people prepare for retirement and ask what is an annuity, they have little to no background knowledge in what this type of investment is or how it works. This is an investment that a life insurance company usually sells. In the case of an annuity, you may make a lump sum investment or make a series of regular payments to purchase the annuity over time. After you fully fund the annuity, it will begin paying you money back. This usually occurs after the age of 59. You can set up annual, quarterly or monthly installment payments. You can also select to receive the payments for the rest of your life or for a specified number of years. The annuity will completely consume the funds, and you may not receive any funds back after the annuity term expires.
By asking what is an annuity, you should understand that there are both fixed and variable annuity products. A fixed annuity provides you with a guaranteed payout over the life of the annuity. A variable annuity will have a payout that stems from the performance of how you invest the annuity capital. While a fixed annuity may be more reliable, a variable annuity may have a higher return in some cases.
A wide range of factors will affect your payout amount. For example, the amount of your initial or upfront investment, the length of your return period, whether you have a fixed or variable annuity and more all play a role in the payout amount that you will receive. You can use an annuity calculator online to begin learning about the different payout structures available. And estimating, as a result, how much money you may want to invest in an annuity.
Keep in mind that some annuities address couples, and the surviving spouse may continue to receive the funds after you pass away. It is important that you understand how the funds will pass on to your heirs before you purchase an annuity. In some cases, any remaining funds in the annuity are lost when you pass away.
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Advantages and Disadvantages of an Annuity
After you learn what is an annuity, you may see that an annuity is truly beneficial in many instances. However, this type of investment product is not ideal for all investors. Before you invest in an annuity, you need to have a clear understanding of the benefits and drawbacks associated with annuities.
Advantages of Annuities
By asking what is an annuity, you can see that there are several advantages that you can enjoy when you purchase this investment.
- A reliable source of income. If you purchase a fixed annuity with lifetime benefits, you will have a truly reliable stream of income that you can enjoy for the rest of your life. This can reduce financial concerns that you may have and can help you to enjoy retirement more fully.
- No taxation. In comparison to tax-advantaged retirement accounts, annuities may be a better option in some cases. While annuities use taxed money as an up-front payment, the payments or growth on the annuity are not subject to taxation. This keeps your tax liability as low as possible in your retirement years. In addition, an annuity does not have a contribution limit on it like tax-advantaged retirement accounts have. If you are trying to catch up on your retirement saving efforts later in life, the lack of contribution limits in annuities can be helpful.
- Annuities are life insurance products. The return that you receive will be based in large part on your age and gender. Investors use the income to supplement other forms of retirement income, such as Social Security income or retirement account distributions. When you diversify your streams of income in retirement, you may be able to retire with a greater sense of security.
- Flexibility. Many investors enjoy the flexibility offered by annuities. You can choose how much you want to invest, how long you want to receive payments for, the return that you want on the investment within reason and more. This gives you the extreme latitude to manage your finances as desired in the later years of your life.
Disadvantages of Annuities
Just as there are advantages associated with annuities, there are also a few drawbacks to consider. When you examine the disadvantages of annuities, you may be able to determine if this is an investment option that is right for you.
- Fees. Perhaps the most significant downside associated with an annuity relates to the fees. Investors usually have to pay a commission to the life insurance agent who sets up the annuity. This fee may be negotiable, but some investors may pay as much as ten percent. This can be a dramatic burden for investors.
- Diminished return. The return on your investment may sometimes be diminished by annual fees on the annuity. While other investments, such as mutual funds, also have maintenance fees charged each year, annuity fees can be rather steep. For example, you may pay one to two percent in annual fees on mutual funds. But the fees on annuities may be three percent per year or more.
- High surrender charge. Some investors also, unfortunately, need access to their capital after they purchase an annuity. For example, you may have unexpected home damage. And you may need to make repairs that are not covered by your home insurance policy. Cashing in the annuity is possible, but it can be expensive. The typical surrender charge is approximately seven percent, but this varies. If you surrender it within the first calendar year that you own this investment, you may pay a fee. It can be as high as 20 percent to the annuity or life insurance company.
- Funds not passable. Another point to consider is that some annuities do not pass benefits on to heirs or a surviving spouse. When you set up your annuity, ensure that you understand what happens to any funds you don’t use and that you are comfortable with this structure.
Annuity products, as well as their returns and fees, vary from life insurance company to company. Now that you know what is an annuity, the concept of having a stream of income payments for a period of time or for the rest of your life will please you. However, it is important to shop around and to compare rates and terms before you make a purchase. In addition, always read the fine print so that you have a better idea of what your specific annuity entails before you make the investment.