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An annuity is a tax-deferred investment vehicle packaged as an insurance product. When you buy an annuity, its earnings are tax-deferred until you begin withdrawing the money. In other words, it works the same way as a nondeductible IRA. Because you're not paying taxes along the way, you have the chance to earn gains on untaxed money, and it grows much more quickly than a taxable account does (depending, of course, on the investments you've chosen). But the guaranteed payments promised in an annuity contract come at a price: providers charge a variety of fees for the management and insurance of the annuity.

An annuity has two phases: the accumulation phase and the distribution phase. During the accumulation phase, you can contribute as much as you want and the earnings in the annuity grow tax-deferred. During the distribution phase, you can elect to receive a lump sum or you can annuitize. Annuitizing means you turn your annuity into a stream of monthly checks for life or for a chosen certain period of time. The security of knowing you'll get income for a specified period, or for life, is one of the real advantages of annuitizing. Distributions and withdrawals are generally taxed as income.

An annuity consists of an insurance "wrapper" and a "subaccount." The subaccount is simply the annuity's underlying investment--typically a mutual fund. The insurance wrapper is the more complicated part of the annuity. It defines the terms of the annuity, such as:

  • Whether it's fixed or variable.
  • Whether it's a certain or life term annuity.
  • Whether it's deferred or immediate.
  • The annuity's death benefit (if any).
  • Surrender charges (if any).

Key Benefits of Annuities

  • Earnings grow tax-deferred until withdrawal
  • Receive specified amount of income during retirement
  • You can switch between investments in your annuity tax-free
  • Contribute as much as you want during the accumulation phase

Fixed or Variable?
There are two broad types of annuities: fixed and variable. A fixed annuity, the more conservative choice, provides a set return backed by an insurance company, much as a bank provides a stated rate of return on a certificate of deposit. Although the rate of return varies somewhat depending on prevailing interest rates, the return is still more stable than the variable annuity's.

A variable annuity invests in stocks, bonds, or money market funds, depending upon the type of subaccount you choose. Usually, you select the subaccount based on the level of risk and return you want in your annuity, just as you would when purchasing a mutual fund. As you would expect, the more conservative subaccounts invest in money markets and bonds, and the more aggressive invest in stocks. The amount of return depends on the actual return of the subaccount investment.

Certain or Life?
If the payout phase of an annuity is for life, it pays the owner during his or her entire lifetime. The payments cease when he or she dies. If an annuity's payout is "certain," it pays the owner for a specified period, and if the owner dies before the period ends, then a beneficiary receives the payments until the certain term ends. In other words, if the annuity owner has a certain term of 10 years for an annuity but receives only 5 years of payments before dying, then the owner's beneficiary will receive payments for another 5 years, and then the payments would cease.

An annuity can also be a combination of life and certain terms. For example, you can purchase an annuity for "life," but with a certain period of ten years. If you live longer than the ten-year period, the annuity continues to pay throughout your lifetime, and at your death, the payments cease. If you die before the certain term expires, your beneficiary will receive payments until the certain term ends.

Deferred or Immediate?
You can purchase a deferred annuity, which means you intend to wait a while and let the annuity earn money before withdrawing from it, or an immediate annuity, which begins paying you immediately. You can also convert your annuity from a deferred to an immediate annuity.

Death Benefits
Depending on how you have set up the beneficiaries to your annuity, your heirs may receive money from your annuity when you die. Here are some examples:

Deferred annuity: If the owner dies while the annuity is still in the accumulation phase (the phase before the payout phase), the owner's heirs will receive whatever amount has accumulated in the annuity. (The heirs will need to pay income taxes on any gains, not to mention estate taxes, if the entire estate amounts to more than $650,000.) In other words, if you contributed $50,000 to an annuity, and it has grown to $150,000, your heirs would receive the principal plus $100,000 as taxable income if you died before the payout phase began.

In some cases, the insurance company may guarantee to pay your beneficiary the principal amount of your investment if it's greater than the account's current value--a real boon if the market drops before you do.

Certain annuity: As noted before, if you purchase a "certain" annuity, the payout phase has begun, and you die during the certain period, your beneficiary will receive payments until the end of the certain period.

Annuity providers charge a variety of fees, which have gone down significantly in recent years. Here's a summary of the types of fees your annuity may charge. (But each plan is different, so you need to compare annuities' fees carefully when making your choice.) Here's a hint about annuity fee quotations: they're often quoted as basis points instead of percentage points. So a fee of .55% is referred to as "55 basis points."

Insurance fees: These fees, also known as mortality fees, are similar to premiums for term life insurance. You pay a certain percentage of your annuity's value to the annuity provider each year in exchange for some type of guaranteed payment. (See above for the different types of guarantees available.) According to the Wall Street Journal, the annuity industry average is 1.25%.

Management fees: These are identical to management fees charged by mutual fund companies. You pay the annuity provider for the management of the subaccount.

Surrender charges: Some annuities charge a substantial penalty if you cash in on your annuity too soon. For example, an annuity might charge a 7% surrender charge that decreases by one point each year for seven years, which means that if you cashed in after one year, you'd pay 6% surrender charges; after 2 years, you'd pay 5%, and so on.

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