What Is An Annuity?

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Life insurance can provide much needed financial support after retirement and as you get older. It also ensures you can provide for your beneficiaries, such as a spouse or next of kin, after your death. However, life insurance isn’t your only option – some people choose to purchase an annuity instead.

An annuity may share a few commonalities with life insurance but is, in fact, very different.

In this article, we’ll explain what an annuity is, how it differs from life insurance, why you may want one and where you can purchase one.

What is an annuity and how does it work?

An annuity is a long-term investment that guarantees consistent income when you get older. Here’s how it works: when you purchase an annuity, you pay the annuity company a certain amount of money each month and then your lender invests part of those monthly payments and grows your money over time.

With an annuity, you essentially develop a savings account. When you reach retirement age, your lender will pay you a certain amount each year until the annuity runs out or until you die. You can’t lose money with an annuity, although there’s no guarantee of how much your money will grow.

An annuity company uses a mortality table to determine how much money you need to pay each month. The table shows the company how much they’ll spend to compensate you over a certain time period, how much risk you carry and how likely the company is to lose money on your investment.

Annuities are commonly used as income replacement for the main policyholder. However, most annuities do have a death benefit. If the policyholder dies, their beneficiary is able to claim the money in a lump sum or receive the payments in installments over time.

Here’s an example of an annuity in real life. Say you buy an annuity at age 40 and you agree to pay the annuity company $100,000 over 30 years, until you’re 70. Every time you make a payment, part of the money gets invested and it grows in the market over time. When you turn 70 and you’ve paid the full $100,00, you’re able to start claiming the funds.

Let’s say at age 70, your money has grown to $350,000. Your annuity company will start paying you a percentage of that money every year, maybe $60,000. So every year, starting at age 70, you’ll receive $70,000. You’ll keep receiving the annual payments until the money runs out or you pass away. If you pass away before the account is empty, your beneficiary will start receiving the money.

However, there’s one catch. Taking money out of an annuity isn’t as easy as simply calling your annuity company. After purchasing an annuity, there is a surrender period—which usually lasts 6-8 years—before you can start withdrawing the money for free. If you need to take money out during the surrender period, you’ll be charged a percentage of your money as a penalty.

Different types of annuities

There are two main types of annuities, and the type of annuity you have determines your interest rate. A fixed-period annuity pays you for a specific number of years. If you die before the period ends, your beneficiaries get the funds. A lifetime annuity, which is the more common option, will continue paying you for the duration of your life.

When it comes to interest, a fixed-period annuity earns interest at a fixed rate. You determine the rate when you purchase the annuity. For lifetime annuities, interest accrues based on market trends and performance.

The difference between life insurance and annuities

Life insurance and annuities are very different and it’s important to understand the differences if you’re thinking about purchasing either. First, life insurance is typically used to leave money to your dependents—a spouse, kids or heirs who need financial support after you die. An annuity offers guaranteed income after retirement and is used as more of a financial safety net as people get older.

An annuity is tax-deferred, so you’ll be taxed on the money when you receive the annual payouts. However, annuity death benefits are not tax-deferred. With life insurance, any funds that are passed on to your beneficiaries are tax-free, so they won’t have to pay anything in order to claim the funds. In general, the death benefits for a life insurance policy are much more robust than an annuity.

The other difference between life insurance and annuities is the payout. With an annuity, you generally receive the payments over time as a form of annual income. With life insurance, you or your beneficiaries receive the payment in a single lump sum. If you need to pay for things like medical bills or funeral expenses, having the money in a lump sum can be beneficial.

Where to purchase an annuity

You can buy an annuity through most investment brokerages, like AIG, Raymond James, Morgan Stanley and Merrill Lynch. Many life insurance companies also sell annuities, such as Sagicor, Americo, New York Life and Bankers Life and Casualty.

Before purchasing an annuity, it’s a good idea to look at the financial strength rating of the company you’re choosing. Organizations like AM Best and Moody’s rate companies based on how much money they have and how likely they are to be able to pay you down the line.

Frequently asked questions

Are annuities a good investment?

Annuities are a good investment for some people. However, keep in mind that annuities are tax-deferred. Although your money will grow more overtime, there’s a chance you’ll have to pay a large amount of money in taxes before you can start getting your payout. If you’re worried about your finances after retirement and don’t have any other streams of income, like an IRA, consider looking into an annuity.

Can you lose your money in an annuity?

No, one of the perks of an annuity is that you can’t lose money. You will be entitled to the value of the principal, regardless of market performance. However, you could lose a significant amount of money if you withdraw funds during the surrender period within 6-8 years of buying the annuity.

Who are annuities best for?

Annuities are best for people who want guaranteed income after retirement. For instance, if you don’t have any retirement accounts, a pension or other stream of income, an annuity can provide that financial security.