Frequently Asked Questions > Life Insurance > What is an annuity?
An annuity is a financial contract issued by a life insurance company designed to provide a steady stream of retirement income. In return for a sum of money, paid either in one lump-sum (known as an immediate annuity) or in regular installments (known as a deferred annuity), the insurance company guarantees a regular income for the rest of your life so that you won’t outlive your assets.
The cost of an annuity depends on how much monthly income you want to receive, your age when you buy the policy and the time when you want to start receiving income. The cost will also vary depending on whether you invest in a lump-sum or in installments.
When you price an annuity, compare the returns promised, sales charges, surrender charges and payout rates.
There are two kinds of annuities:
- Fixed annuities.
These guarantee a fixed rate of return for a specific period of time, usually one to five years. The insurance company invests your money in a fixed rate vehicle like a bond or mortgage to provide this return. When you begin to withdraw the money from the annuity, you are guaranteed a specific minimum amount each pay period. - Variable annuities.
These offer you various options to switch among stock, bond and money market funds. Some funds are actively managed to beat the benchmark indexes, while others, known as index annuities, are tied to popular indexes like the Standard & Poor’s 500.
Annuities offer tax advantages, because all returns compound tax-deferred until the money is withdrawn. Once you start to receive a monthly payment, you will be taxed on the accumulated interest and capital gains. Part of each payment is considered interest and is taxed as regular income, while another part is considered return of principal and is not taxed.
If you withdraw money from an annuity before age 59 1/2, the interest and capital gains earned must be withdrawn first and subject to regular income taxes and a 10% early withdrawal penalty, just as you have to pay when withdrawing early from an IRA.
When it comes time to receive payments from an annuity, you have several choices to make. These are your four options:
- Straight life annuity.
You receive a fixed income for the rest of your life. Whether you get back all of the money you put into the annuity depends solely on how long you live. After you die, no more payments will be made to the beneficiaries. This type of annuity will maximize your monthly payments, but would not be appropriate if others, such as your spouse or children, will need to live on your income once you have died. - Joint and survivor annuity.
You and your spouse, or designated beneficiary, receive a payment from the insurer as long as both of you live. The monthly payments will be less than you would receive in a straight life annuity because the insurance company must pay benefits for a longer time. - Life income with refund annuity.
If you die before having received all the money you put into the annuity, your beneficiary receives the money you have not been paid. - Life annuity with period certain.
The annuity makes payments for a specified number of years -- usually 10 or 20 years -- after you start receiving payments. If you die before the period has elapsed, your beneficiary, usually your spouse, will continue to receive the payments for the balance of the period.
Last updated on January 13, 2010 by Bob