How do Annuities Work?

If you're considering an annuity as a way to supplement retirement income, you must first know how annuities work. In general, you would make a payment to an insurance company, and then the insurance company would make regular payments to you based on the terms of your contract.

Annuities generally are used for retirement purposes and can be tax deferred. You can purchase an annuity with one large payment or in a series of payments. The term for an annuity can be a defined period, such as 25 years, or an undefined one such as your lifetime or the lifetime of you and your spouse.

Before you buy, think about when you want to receive your payments. You can choose immediate payments or deferred payments, which may be smarter if you are far from retirement. If you have a spouse, you should think about how the plan will affect him and if he will receive payments should you die before he does.

You may also experience sticker shock with an annuity. The amount you pay for the feeling of security that comes with a steady check can be high. If you try to withdraw funds or close the annuity, you might be hit with a steep penalty. Furthermore, some of those who sell annuities have been under scrutiny for pushing these products on seniors who may not fully understand them.

You have three basic annuity options to choose from: fixed, variable and indexed or equity-indexed.

Fixed Annuity:  With a fixed annuity, an insurance company takes what you paid and puts it into a fixed fund. The amount that you receive from the insurance company will not change, which is great if the economy is rough, but you might feel like you're missing out during the good times, and inflation might take a bite out of the returns.

Variable Annuity:  This annuity is linked to the performance of a managed portfolio, which means the amount you receive will change based on the market. If the portfolio is doing well, a great return is expected. If it's not doing so well, the return can be low, or it will be just the guaranteed minimum the insurance company states in the contract.

Indexed or Equity-Indexed Annuities:  Mixing characteristics of fixed and variable annuities, these annuities have returns based on how well a market index such as the Standard and Poor's 500 (S&P 500) is doing. While your payout can vary, your principal remains protected, even while the equity market experiences losses. However, you might not wind up with as much of an index's return as you think. Ask for a full explanation of the returns you may sacrifice in exchange for security.

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.