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What is an annuity?

Daniel Walker
Licensed Insurance Agent for 15 Years

UPDATED: Mar 19, 2020

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What is an annuity?Among the various investment vehicles being used to support retirement goals, annuities are gaining popularity over stocks and 401k plans. An annuity allows the investor to make tax free contributions over a period of time, or even in a lump sum, to be paid back sometime in the future.

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Annuities are safe investments for the most part, so they are attractive in troubled financial times. Learn how annuities are administered, what makes them attractive, the risk involved, and the tax ramifications in the remainder of this article.

Annuities and Insurance Companies

Annuities are usually administered by insurance companies who turn around and invest your money in other ways. Be it stocks, bonds, or various equity investments, the insurance company makes money off your money. In return, they guarantee to pay you back at a later date with an amount greater than you paid in.

If this sounds just as risky as investing in the stock market on your own, it’s not. When you invest alone you are at the mercy of the markets. With a fixed rate annuity however, your guaranteed return will be paid out regardless of the market conditions, provided the insurance company remains healthy.

Annuities are Low-Yield Investments

The nature of an annuity reduces the risk for the investor while at the same time reducing the net gain of the insurance company administering it. For this reason, interest rates on annuities are rather low. It’s not uncommon to see rates between 1.5% and 4% annually, even though some annuities offer a guaranteed 8% to 11% for the first year of the contract.

Investing in annuities requires an understanding of how returns are calculated for the life of the contract. Insurance companies have been known to pad an annuity with various fees to avoid paying a return higher than what they anticipated. A qualified investment manager who doesn’t make his or her living off of annuities is the best source of advice. Otherwise, the complex nature of these investments can be quite discouraging.

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Fixed Rate Annuities vs. Variable Rate Annuities

The fixed and variable rates attached to annuities work the same way as with any financial product. A fixed rate guarantees the investor a specific return on his money that will not change for the life of the contract. A variable rate will fluctuate with market conditions.

While the variable rate holds the promise of higher returns, the one caution to consider is that the money you paid in is not guaranteed to come back out. In other words, you could still lose.

Which type of rate you choose really depends on your taste for risk. Due to the low-yield nature of annuities however, it would seem that most who invest in them would stick with the protection of the fixed rate. There’s no need to risk the loss of principle with a variable rate annuity if the return is still lower than traditional investments.

Tax-Related Annuity Issues

One of the reasons annuities are used as retirement vehicles is the fact that the money paid in is tax deferred. That means the investor doesn’t pay income taxes on that money until he or she withdraws it from the annuity. How those taxes play into an overall retirement plan is something to be discussed with your financial planner.

For all the benefits of the annuity investment, there is one drawback in the area of taxes that ends up being a deal breaker for many: taxation of death benefits. The annuity will pay a final death benefit to the estate of the deceased, but then the government will turn around and tax it both as regular income and estate assets. This dual taxing can sometimes be enough to virtually wipe out any death benefit payment.

Create a Sound Financial Plan

Any financial plan designed to get an individual through the retirement years needs to be sound enough to weather potential financial storms. That means the investor should be careful to spread the investments out in several vehicles. There should be some with lower risk and reward, and some with higher risk and reward. This type of strategy allows for maximum protection and maximum yield.

Speak to your financial planner about the possibility of investing in annuities. But also consider the possibility of trying some stocks, money market funds, bonds, and even precious metals. A sound plan is one that weighs the risk and reward, then invests money in such a way as to maximize results.

While you’re thinking about it, online annuity quotes are just a click away if you enter your zip code into the free search tool now!

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