The definition of an annuity is “a specified income payable at stated intervals for a fixed or a contingent period.” For our purposes, annuities are financial products developed and issued by insurance companies. Even though you can buy one at your local bank, the bank does not underwrite annuities. A feature of all annuities is the deferral of taxation. While they are not tax free, the taxes are not due until some point in the future.
There are two basic categories of annuities, immediate and deferred, and many different types within each category. In each instance, the purchaser pays the insurance company a certain amount in exchange for a benefit, either specifically defined, or estimated. The parties to an annuity are the insurance company, the annuitant (the person on whose life the annuity is calculated), the owner (oftentimes the annuitant, but not required to be so), and the beneficiary.
An immediate annuity is one that is described by the definition quoted above. The owner provides the insurance company with a lump sum of cash in exchange for a predetermined periodic benefit that starts immediately (the first payment can be deferred up to one year). That benefit can be paid for as long as the annuitant is alive (lifetime benefit), for a certain period of time, (e.g., 10 years), or some combination of the two (e.g., lifetime with 10 year certain). In the last example, benefits are payable for as long as the annuitant lives, but should the annuitant die before 10 years, the remaining benefits will be paid to a beneficiary.
There are many variations of immediate annuities, some involving joint annuitants whereby a second annuitant will continue to receive benefits after the death of the first annuitant.
A deferred annuity accumulates value before the income stream begins. Primary types of deferred annuities are 1) fixed, 2) variable, and 3) equity indexed (although this is technically a fixed annuity).
A fixed annuity is analogous to a CD; the principal is guaranteed (albeit by the insurance company and not the federal government), and interest is credited periodically. A primary difference is that the interest on the CD is taxed currently, whereas the interest on the annuity is deferred until it is withdrawn.
In addition to a guaranteed account (again, guaranteed by the insurance company, not the federal government), a variable annuity has equity sub-accounts available in which to allocate the initial investment, and has been compared to a tax deferred mutual fund. Generally, funds allocated to the equity accounts are not guaranteed, although many variable annuities have riders that serve to limit the downside. The taxes due on any gains are deferred until a withdrawal occurs. Like fixed annuities, variable annuities are taxed on a LIFO (last in first out) basis.
While the principal is guaranteed, equity indexed annuities offer upside by linking the amount to be credited to an equity index, such as the S & P 500. If the benchmark declines, the annuity doesn't lose value, but it doesn't gain anything either.
There is much more to annuities than presented in this very basic and general article. They can be very complex, but also offer the opportunity to safeguard a portion of your portfolio.
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