How do annuities work?

Annuities are financial products designed to provide a steady stream of income over a specified period or for the lifetime of the annuitant. They are typically offered by insurance companies or financial institutions. Here’s a general overview of how annuities work:

Purchase: To start, an individual or entity (the annuitant) purchases an annuity contract by making a lump sum payment or a series of payments into the annuity. The payment(s) can be made upfront or over a period of time.

Accumulation Phase: During the accumulation phase, the money in the annuity grows on a tax-deferred basis. The annuity may offer various investment options, such as mutual funds or fixed interest accounts, which can generate earnings on the principal amount.

Annuity Options: There are different types of annuities, offering various payout options. The main types are:

a. Fixed Annuities: These provide a guaranteed interest rate for a specific period. The income generated is predictable and stable.

b. Variable Annuities: These allow the annuitant to allocate their funds into different investment options, such as stocks, bonds, or mutual funds. The income generated depends on the performance of these underlying investments.

c. Indexed Annuities: These are linked to a specific market index, such as the S&P 500. The annuity’s performance is tied to the index’s performance, offering the potential for higher returns.

Distribution Phase: When the annuitant decides to start receiving income, the annuity enters the distribution phase. The annuitant can choose from various payout options, including:

a. Fixed Period Annuity: The annuity pays out a fixed amount over a specified period, such as 10 or 20 years.

b. Lifetime Annuity: The annuity provides regular payments for the annuitant’s lifetime, ensuring income security regardless of how long they live. The amount of each payment depends on factors like the annuitant’s age, gender, and interest rates at the time of purchase.

c. Joint and Survivor Annuity: This option covers two people (e.g., spouses), providing payments until both individuals pass away.

Tax Implications: Annuities have tax considerations. During the accumulation phase, earnings grow on a tax-deferred basis. When withdrawals are made, they are generally subject to income tax. Withdrawals before the age of 59 ½ may also incur a 10% penalty.

It’s important to note that annuities can have fees and surrender charges, and the terms and conditions can vary between different providers and contracts. Before purchasing an annuity, it’s advisable to carefully review the terms, understand the costs, and consider seeking advice from a financial professional to ensure it aligns with your specific financial goals and circumstances.