Annuities – How They Work

An annuity is a long-term retirement savings tool, issued by a life insurance company. They are designed to help you accumulate funds and provide a steady stream of income for retirement. It is a contract between you and an insurance company

There are basically two types of annuities, fixed and variable. The one main difference is based on how your purchase payments are allocated. Based on your financial goals, objectives and risk tolerance you should discuss options with your financial adviser.

With a fixed annuity you can count on a guaranteed interest rate at a guaranteed minimum rate of return determined by what annuity you purchase, safety of your principle and flexible income options. Income options means you can choose from a lump-sum payment or equal payments over a period you select, even for the rest of your life. Beneficiaries are guaranteed to receive back at least the principal that you paid in minus any withdrawals you may have made.

A variable annuity has growth potential. Variable annuities fluctuate as they are based on the performance of the investment options you choose for your annuity. The investment options are typically mutual funds that invest in stocks, bonds, money markets or a combination of the three. Variable annuities are different from mutual funds, annuities have a death benefit, you can receive periodic payments for the rest of your life and so can your beneficiary if you should die. Variable annuities are also tax deferred. When you set up your variable annuity you choose from a range of investment options-conservative to aggressive and you can allocate a portion of the money to a fixed account. This allows diversification of the investment and you can transfer from one investment option to another within the annuity tax free. Be careful when you do this as this may extend the period of time that you would have to pay a surrender charge. You also can choose how you will receive the income from the annuity, either a fixed income in equal payments or a variable income stream based on the performance of your investments in the annuity or a lump-sum payment. Variable annuities are more complex, remember to ask about the risks, features, fees and benefits, but know you will be subject to market risks and could lose the principal invested.

There is another annuity called an “Immediate” annuity which can be either variable or fixed. You convert a lump sum of money to an income stream that matches your retirement objectives. You have the choice of how often you receive payments, monthly, quarterly, semiannually or annually, and how long you will receive the payments with the option of all the way to the end of your life.

Annuities are designed to be long-term investments and may have surrender fees that could start as high as 7-10% the first year and gradually decline in ensuring years and could be for as long as 10 years.

Before you invest in an annuity you should understand how they work, what to consider when making a decision and how to avoid common problems. Make sure an annuity is right for you.

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