Understanding Annuities

Annuities are a mystery to many people, partly because they're retirement investment vehicles sold by insurance companies, and partly because there are many complexities involved.

An annuity is an investment vehicle used to provide income during an individual’s retirement years. They

can be purchased in one lump sum or set up so that you can contribute over time. You can also annuitize, which means electing to take monthly payments for steady income. You can dictate how long the income will last — a set number of years, or for the rest of your life or the life of your spouse. The annuity contract states the age at which distributions can be taken, the payment intervals, and other specific terms.

The first significant feature of an annuity is that the money earned from the investments within grows tax-deferred until withdrawal. Therefore, the annuity holder is taxed only when he or she takes distributions, and then only on the income earned. While the holder is taxed at personal income tax rates (not capital gains rates), it's likely that he or she will have a lower income during his or her retirement years.

Another significant point to understand about annuities is that they can be either fixed or variable.

Fixed annuities earn a guaranteed rate of interest for a specified period of time. Once that time period ends, a fixed rate of interest is established. Like CDs, they invest in interest-bearing obligations, meaning they are fairly safe investments, which don’t pay a high rate of interest, but come with very low risk.

Variable annuities offer potentially higher returns, but come with greater risks. There is a much wider range of investment options, including numerous mutual funds. You can also transfer your money from one investment to another within the annuity, and not have to pay taxes on the earnings you've made.

Like most retirement plans, annuities come with stipulations, such as your not being able to withdraw money before the age of 59½ without incurring a penalty. There are also some cautions, such as the various fees that will be attached when you purchase an annuity, and the fact that the FDIC does not protect annuities in the same manner as CDs. However, on the upside, a major advantage of an annuity — and one reason for their popularity — is that there is no limit on how much you can invest. This means that when you’ve maxed out your IRA or 401(k), you can buy an annuity and put in as much as you choose, in an effort to grow your money much more quickly for your retirement years.

Annuities also generally provide life insurance benefits, which can provide all the money in the account or a guaranteed minimum to your beneficiaries. If, however, you already have life insurance, you will probably not opt for such a benefit.

These are just a few of the many details of annuities. It's important to discuss such an investment product with a financial advisor and read the prospectus carefully before buying a variable annuity.