Understanding How Do Annuities Work

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how do annuities work

Thinking about signing up, but don’t know how do annuities work? Read on to understand the basics of this type of savings plan.

In this world of uncertainty, it’s really crucial to invest in something that will reap you benefits in the future. Financial plans are one of the many products offered for people to help them fund their retirement. However, there are so many types of financial plans. With each of them having their own benefits and disadvantages, it can be difficult and overwhelming to understand them all. When it comes to finance, the golden rule is to never invest in something you don’t fully understand.

Protecting yourself is very crucial. Although it takes some effort and time, it’s essential to learn the basics of how do annuities work. Whether you already own one or are just thinking about making a purchase, understanding its benefits will help you determine if this is worth to invest for.

What Is Annuity?

An annuity is a contract between you and an insurance company, in which you make payments in exchange for receiving a certain amount of money for a period of time. It’s a long term investment designed to help protect people from the risk of outliving their income.

When you invest in an annuity, you will set yourself to receive income in the future that can last for a lifetime, depending on the agreement. The payment of premiums can be made either in a lump sum or a series of payments. How much you receive depends upon the type of annuity you opt for.

How Do Annuities Work?

Generally, there are two stages of how annuities work:

1. Accumulation Phase

In accumulation phase, you make payments to your insurance company — either in a single or multiple payments. Those payments are then put into your funds, which grows overtime for your retirement. If, for instance, you make withdrawals during this phase, you will have pay surrender fees, income tax, and federal penalty tax (10%) if you are under 59 ½.

2. Annuitization Phase

In this phase, the accumulated amount is converted into annuity units, which are paid out to the beneficiary in several different ways. Depending on the agreement, annuities can be received monthly, yearly, or on a lump sum basis.

how do annuities work

Types of Annuities

All annuities have the same purpose – to provide a steady stream of income during retirement. However, each type of annuity works differently from each other. It’s important to understand the different types of annuities before you decide to sign for one in order to get the maximum benefits you need.

Two basic types of annuity: immediate and deferred annuities.

  • Immediate Annuity – In this savings plan, you pay a large lump sum amount in exchange for a guaranteed income that starts almost immediately. This is good for retirees who are worried about outliving their savings. The disadvantage is that the contract is immediately terminated upon the death of the policy holder.
  • Deferred Annuity – In this plan, you pay your premiums on a lump sum or periodic payments, which accumulate in your retirement fund. Those funds grow tax-deferred until you start withdrawing them.

In these two categories, annuities can be either be fixed or variable:

  • Fixed Annuity – In this savings plan, you have the option to pay your contributions in either a lump sum or a series of payments. The amount you pay is then accumulated and paid back to you in a specific period of time. This type offers a guaranteed rate of return, of both your principal and earning balance.
  • Variable Annuity – This type of contract provides the greatest returns; however, unlike fixed annuity, variable annuity is not guaranteed.

Other types of annuities:

  • Straight Life Annuity – The contract pays the recipient a calculated amount until his or her death. Even if the payment exceeds the total amount of premium paid by the recipient, the contract will continue to pay. However, the payment completely stops upon the death of the recipient, even the amount of pay is less than the total amount of premium paid. This plan doesn’t allow a beneficiary.
  • Joint Life Annuity – Similar to straight life, this contract pays the recipient a calculated amount until his or her death. But here, it designates a beneficiary, where it guarantees income for the other person upon the death of the policy holder. Usually, the beneficiary is the retiree’s spouse.

What are the Benefits of Annuities?

1. Financial Guarantee. One of the key benefits of this type of financial plan is that your income is guaranteed. If you sign up, you’re guaranteed to receive income until you die.

2. Commissions. Annuities offer the largest commission in the finance industry. If you buy, you can receive more than the total amount you paid for your premiums.

3. Tax Benefits. The accumulated amount in your annuity is tax-deferred until you withdraw them. But even if they are taxable after withdrawal, the tax collected is just the same as ordinary income.

What are the Disadvantages of Annuities?

  1. Irreversible. Once you have signed up for an annuity, you can never back out.
  2. Withdrawal Charges. There’s a “surrender charge” for early withdrawal.
  3. Protection for your family. Most annuities only provide guaranteed payment for retirees until their death. If, for instance, the recipient died, nothing will be left behind in his or her family unless he or she purchased a joint annuity.

Final Thoughts

Annuities are like retirement funds that give you guaranteed and steady flow of income when you reached your retirement age. Generally speaking, they are a good investment, as they provide a lot of benefits. In fact, a huge number of American population owns at least one kind of annuity.

For more information on how do annuities work, contact your financial advisor.



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