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Annuity Basics

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What Is An Annuity?

An annuity is a contract between you and an insurance company that offers a guaranteed income stream for life or a specific duration, with payments starting right away (immediate annuity) or in the future (deferred annuity). In some cases, you may surrender the contract and receive a lump sum.

How Do They Work?

When you purchase an annuity, you pay the insurance company an amount of money in a lump sum or series of payments. The insurance company invests this money and credits interest to your account based on their investment earnings. The funding period is called the accumulation phase. Under current tax law, you pay no federal income taxes on accrued earnings until payouts begin.

In return, you — or a named beneficiary — receive an income for a defined period, for your lifetime or for a beneficiary’s lifetime. This period is called the distribution phase. Receiving scheduled payouts is called annuitizing the contract.

When you begin receiving a stream of income, you receive your contributions plus any earnings that may have accumulated. You are taxed for federal income tax purposes only on the amount of earnings received. Generally, the principal (the amount you contribute) is not subject to federal income tax because you pay premiums with after-tax dollars. If your annuity is an individual retirement account (IRA), your contributions may be taxed for federal income tax purposes when withdrawn.

Who Should Have One?

You can benefit from an annuity if you:
  • Contribute the most you can to employer-sponsored retirement plans such as 401(k) or 403(b) plans and need to save more for retirement.
  • Have already contributed the maximum to a Roth or traditional IRA — or your adjusted gross income (AGI) prohibits you from contributing to such accounts.
  • Already have investments or savings accounts that can be quickly converted to cash.
  • Need to generate a guaranteed, steady income for retirement.
  • Need to ensure a steady income for your spouse or another beneficiary after your death.
  • Expect to be in a lower tax bracket in the future.
  • Want protection, safety and guarantees for your money.

Other Considerations

When purchasing an annuity, you should know the following.
  • Costs may include annual fees, investment management fees, insurance expenses and other charges. Extra features such as long-term care riders and liquidity options typically have costs associated with them.
  • Some annuities offer death benefit protection or the option of continuing payments to a beneficiary after your death. This may avoid the time and cost of probate for these funds.
  • Because earnings are taxed for federal income tax purposes only when you withdraw funds or receive payouts, you may pay less federal income taxes than with other investments.
  • You can generally withdraw only a certain amount from your contract without penalties.
  • Your scheduled income payments remain the same once you begin receiving them. (This does not apply to IRA required minimum distributions.)
  • There may be a 10 percent Internal Revenue Service (IRS) penalty in addition to regular federal income tax if you withdraw annuity savings before age 59½.
  • Annuities are guaranteed by the company offering the annuity and then backed by guaranty associations in most states, not by the federal government.

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