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Annuities explained

Dear Money Matters,
What exactly is an annuity?
-- Sara

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Dear Sara,
Annuities are sold by insurance companies, but are decidedly different from an insurance policy. In essence, you buy an annuity in exchange for a series of payments that are distributed at specific points of the life of an annuity contract. Many annuities have an indefinite payout schedule; the longer you live, the more you receive.

Not surprisingly, annuities come in various types. First, you can choose whether you want to receive payments right away or put them off until later. This is the primary difference between "immediate" and "deferred" annuities. Additionally, you can choose between a fixed annuity and a variable product. A fixed annuity has an established payment that the company usually announces on an annual basis. By contrast, a variable annuity is effectively an insurance product wrapped in a mutual fund. You as the owner of the annuity can choose how your annuity funds are invested. Your choices include stocks, bonds and money markets. It has a set payment amount that may be augmented by additional payments depending on how the annuity's investment portfolio has performed.

Personal circumstances dictate what sort of annuity may work best. For instance, many retired people buy immediate annuities to provide a steady stream of reliable income. By contrast, younger people may opt for deferred annuities. The primary reason is that money in the annuity grows tax-free until they set up a regular payout schedule.

However, approach annuities as you would any sort of investment decision. For instance, don't make the mistake of providing unnecessary layers of tax-free growth. Following a similar statement from the National Association of Securities Dealers, the Securities and Exchange Commission recently declared that variable annuities often are unsuitable investment options when part of a tax-deferred retirement plan, such as a 401(k) or an individual retirement account. Since those are already tax deferred, the SEC pointed out that buying a deferred annuity meant that investors merely paid extra fees to an insurance company for tax benefits they are already receiving free of charge.

Taking that point a step further, be sure to keep an eye on fees and expenses associated with annuities. Not only do various annuities levy all different sorts of costs, some hit you with significant penalties if you choose to take your money out of the contract within the first five or 10 years.

Bankrate.com's corrections policy-- Posted: April 11, 2002
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