What is an Annuity?

an·nu·i·ty    /əˈn(y)o͞oitē/

Noun: 

  1. A fixed sum of money paid to someone each year, typically for the rest of their life.
  2. A form of insurance or investment entitling the investor to a series of annual sums.

An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-range goals. When you purchase an annuity, you make a lump-sum payment or series of payments. In return, the insurer (the insurance company) agrees to make periodic payments to you (the insured) beginning immediately or at some date in the future.

Annuities typically offer tax-deferred growth of earnings. They also may include a death benefit that will pay your beneficiary a specified minimum amount. While tax is deferred on earnings growth, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates. This is an important consideration with annuities.

There are generally four types of annuities — immediate, fixed, indexed, and variable. An immediate annuity will begin to make income payments to you immediately. The other three types of annuities are generally classified as deferred annuities. In a fixed annuity, the insurance company agrees to pay you no less than a specified interest rate during the time that your account is with them.

In an indexed annuity, the insurance company credits your account interest based on changes in an index, such as the S&P 500 Composite Stock Price Index or the Dow Jones Industrial Average Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance. However, asset fees, participation rates, caps and contingent deferred sales charges may apply. Indexed annuities are also commonly referred to as hybrid annuities or fixed-indexed annuities.

In a variable annuity, an investor can choose to invest their purchase payments from among a range of different investment options, generally mutual funds. The rate of return on your purchase payments will vary depending on the performance of the investment options you have chosen. Because variable annuities involve investing in securities, these types of annuities carry an inherent element of risk and may lose value.

 

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Annuities are best suited for long term investors. Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax. Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time. Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.

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