It’s an insurance product you buy to save a significant amount of money. Annuities are a contract between you and an insurance company and offer a way to reduce taxes and/or ensure a steady flow of income.
People typically buy annuities if they:
- Need to save significantly.
- Want an investment that reduces taxes.
- Want to ensure a steady flow of income.
How annuities work
When you buy an annuity, you either pay a large, single premium or make payments for a period of time in exchange for a future income. Until you withdraw money or begin receiving payments, the annuity will grow on a tax-deferred basis.
When it’s time to receive your income from the annuity, you can request regular, fixed payments or take the money out in one lump sum. A popular payout option is a “lifetime income with 10 years certain.” This means the annuity pays a monthly income for the life of the annuity owner or for 10 years, whichever is longer.
What are the benefits of an annuity?
Annuities provide three main benefits:
- Death benefits: The basic death benefit offers a guarantee that when you die, the insurer — at a minimum — will pay out the amount you paid in.
- Living benefits: People often buy annuities with retirement in mind, because annuities can pay out in lump-sum amounts or provide a guaranteed income for as long as they live.
- Tax deferral: You aren't taxed on any interest, dividends or capital gains that accumulate inside of your annuity contract until you take a withdrawal. However, if you withdraw money prior to age 59 1/2, you may be subject to an additional 10% penalty tax.
Types of annuities
There are three different types of annuities:
Fixed annuities
In a fixed annuity, your money — minus any applicable charges — earns interest at rates set by the insurer. The rate is specified in the annuity contract.
Variable annuities
The insurer invests your money — minus applicable charges — in a separate account. The company invests your money in stocks, bonds or investment funds you choose, based upon your risk tolerance.
If the fund doesn't do well, you can lose all or some of your investment.
Equity-indexed annuities
With an equity-indexed annuity (PDF, 280KB), the insurer offers a guaranteed minimum return, plus it offers a variable rate based on the return of a specific index. During the accumulation period, the insurer credits you with a return based on interest earned plus or minus changes in the index, subject to participation rates, caps, charges and other restrictions.
The most commonly used index is Standard & Poor’s 500 Composite Stock Price Index (S&P 500).