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What is an Annuity?

what is a savings annuity

One way to guarantee a steady stream of income for life is through an annuity. An annuity is an insurance contract that can help build savings for retirement and convert savings into income that cannot be outlived.

With an annuity, an insurance company agrees to make a series of income payments—or payouts—to you in exchange for the premium(s) that you pay. An annuity is a long-term retirement security product. It is not meant to be used to meet short-term financial goals. An annuity is the only financial product that can guarantee lifetime income.

An immediate annuity turns premiums into a series of income payments from an insurance company that begin within a year after you buy it. The annuity owner decides how often (monthly, quarterly, or annually) and how long (over a set number of years or for as long as you live) payouts are received. People usually buy this type of annuity with money from the sale of a home or business, life insurance benefits, or a savings account. Retirees also may use some of the money they have in a retirement plan—such as a 401(k) or IRA—to purchase an IRA annuity.

A deferred annuity allows savings to grow tax-deferred until payouts begin. A deferred annuity can also be a way to save for the future and for income after retirement. People who are years away from retirement—or are retired and have assets but don’t need income right away—might choose this type of annuity.

In a deferred annuity, the period of time before payouts are received is called the accumulation phase. There are different types of deferred annuities that let the annuity owner decide how his or her money grows during this time (accumulation options). The different types are fixed, index, or variable annuities.

A fixed annuity earns interest at a rate that is guaranteed for a set period of time. This time period is defined in the contract and ranges from one to five years or even longer. After that period of time ends, a new rate may take effect or the old rate may be offered again. The contract guarantees a minimum accumulation rate. The new interest rate will never be less than the minimum rate.

An index annuity is a type of fixed annuity and is sometimes called a fixed index annuity. With an index annuity, earnings accumulate at a rate based on a formula linked to the change in one or more published equity-based indexes. An example is Standard & Poor’s 500 Composite Stock Price Index, which tracks the performance of the 500 largest publicly traded securities. The index and the formula that determines how the index is used to calculate the rate can vary from annuity to annuity. An index annuity contract also may guarantee a minimum accumulation value.

With a variable annuity . an insurance company puts money into subaccounts that are invested in stocks and bonds. The type of funds selected depends on the level of risk the annuity owner is willing to take. For each investment available, the annuity prospectus—which is required by law to be given to potential buys—outlines the objectives, level of risk, and operative expenses. The prospectus also includes the investment’s financial statements. In some instances, variable annuities can present a higher risk than other forms of annuities. The risk primarily depends on the performance of the investment options chosen; some investment choices might result in a drop in the annuity’s account value.

Premium Options

Depending on the type of annuity, there are generally three ways of paying for it:

Immediate and deferred annuities can be purchased with a single premium payment.

Retirees often purchase single-premium immediate annuities with money from an employer-sponsored retirement plan, savings account, the cash value (or

death benefit) from a life insurance policy, or the sale of a home.

Deferred annuities have the option of periodic level premium payments of equal premium amounts at regular intervals until the payouts are scheduled to begin, or periodic flexible premium payments over a set period of time, but the premium amount paid can vary and the owner can skip making deposits.

Annuity Benefits

Most annuities have death benefit protection. If the annuity owner dies before payouts begin, the beneficiary will receive at least the amount contributed, less any withdrawals you’ve taken. With a variable annuity, the death benefit is either the current account value less withdrawals or what has been paid in premiums, whichever is greater. These benefits are explained in each annuity contract.

If the annuity owner dies after payouts start, depending on the type of annuity chosen, the beneficiary receives the remaining value of the annuity.

Some variable annuities offer guaranteed living benefits for an extra cost. For example, There may be additional living benefit options available if the annuity owner needs long-term care services.

Tax-Deferred Growth

Earnings in an annuity build up free of current federal income tax. When money is withdrawn or income payouts are received, the part that comes from earnings is taxed as ordinary income. The part of the payout that represents the premium is not taxed if the annuity was purchased with after tax dollars.

Unlimited Contributions

There are no tax code restrictions on the amount of money one can contribute to an annuity. This provides additional flexibility compared to other retirement savings plans, such as 401(k)s or IRAs, which place limits on how much can be contributed each year.

Access to Your Money

Payout Options

Annuities offer flexibility in the way payouts are received. Some common forms of payout include:

Life income: With this option, payouts are received for as long as the annuity owner lives, even if the total payouts are more than he or she paid in premiums. Upon death, no further payouts will be made to anyone, not even dependents. This income option, also known as a straight life option, usually pays the highest total income payout.

Joint and survivor life income: This option provides income for as long as the annuity owner or the surviving beneficiary lives. The total income payout is less than in a life income option.

Life income with refund: With this option, payouts are received for life, but upon death, the beneficiary receives an amount equal to the premiums that have not yet been received.

Life annuity with period certain: Payouts are received for as long as the annuity owner lives. When the annuity is purchased, a period of time is selected, typically 10 or 20 years. If death occurs within the period certain and income is being received, the beneficiary will receive regular payouts for the rest of that period.

Options Without Life Income

Annuities offer other income options that don’t guarantee income payouts for a lifetime. For example, one can choose to receive income in a series of payouts for a set number of years, or as with a deferred annuity, in a lump sum.

Withdrawal Options

Most deferred annuities allow a certain percentage (usually 10%) of money to be taken out each year during the accumulation phase (when the annuity owner is still paying premiums and hasn’t yet started to receive payouts) at no cost.

If money is withdrawn from an annuity or if an annuity is cashed in early, there may be a surrender fee or withdrawal charge in the early years of a contract. Withdrawals from an annuity also may reduce the death benefit available or any guaranteed living benefit.

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