Annuities – What They are and how They Work

how do annuities workAn annuity is an investment product designed to provide a nest egg or income stream for retirement. Annuities provide similar tax benefits to an IRA, and like other types of investments, have unique benefits and drawbacks.

How do Annuities Work?

Like an IRA, an annuities allow you to defer taxes on investment gains, meaning you only pay taxes on income when you withdraw funds. There are also stiff tax penalties for taking out money before you are 59 1/2 years old. (learn more about early withdrawal penalties here.)

Another major benefit of annuities is that you can make unlimited financial contributions.

This is in contrast to an IRA or 410 (k), which have strict limits on the amount you can contribute (less than $20,000 per year). Generally speaking the fees associated with annuities are greater than for an IRA, and the investment choices can be more limited.


How annuity distributions work

An annuity is essentially a contract between you and an insurance company. When you buy an annuity you can either pay a large lump sum up front, or make a regular series of deposits over a scheduled amount of time. In the case of an Immediate annuity, the insurance company then agrees to start paying you money on a certain date, and will continue to make payments to you for either a fixed amount of time (i.e. twenty years) or until you die. These payments are called distributions. When purchasing your immediate annuity, you can chose for distributions to be a fixed dollar amount, or for them to fluctuate based on market performance.

If you don’t want to receive scheduled distributions from an annuity, you can buy a Deferred Annuity. In this case, your investments will grow (like and IRA account) until your ready to use the money.


Annuity Issuers

The insurance companies that issue annuities expect to make a profit on the annuity. They calculate how much they expect to earn from investing your money and in effect are giving you the majority, but not all, of their expected returns. The insurance companies have an advantage over many money managers. in that they have the ability to invest your money over long periods of time. In theory, this frees them from being distracted by short-term market movements, enabling them to use their best judgement in picking longer-term investments.


Annuity Types

The type of annuity that is best for you depends on how much income you would like to receive and how much risk you want to take.

Fixed Annuities: Behave very similarly to a certificate of deposit (CD). You are guaranteed your principal and interest by the insurance company. You can read more about fixed annuities here. (learn more about fixed annuities here.)

Variable Annuities: Behave in a similar way to a mutual fund. You can lose both principal and interest, however, you have the potential for double digit returns when the stock market is rising. You can read more about variable annuities here.

Indexed (or fixed index) Annuities: Combine features of both fixed and variable annuities. Your principal is guaranteed by the insurance company. However, the return is determined by the performance of stock market index. You can read more about indexed annuities here.



Annuities are not for everyone. If you are currently at the maximum contribution level for your IRA or retirement account, we believe annuities are worthwhile to investigate due to their tax advantages.

As you can tell, there are all sorts of annuities. Immediate and Deferred. Fixed, Variable, and Indexed. Before you talk to annuity sales person, we suggest that you already have in mind the type of annuity that best suits your income needs and risk tolerance.

This lesson is part of our Free Guide to Investing in Annuities.  Continue to the next lesson here.
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