Annuities are an excellent way to generate a lifetime income, save for retirement without the worry of market risk and leave something to your family or a favorite charity after you die. However, like many financial products, what was once a simple idea has become very complicated. In this article, we outline the three main types of annuities - fixed, variable and indexed - and tell you what to look for in each, as well as what questions to ask before you invest.

Annuity 101
An annuity is a financial product sold by insurance companies or other financial institutions to hold and grow funds. When you annuitize, you accept a payout stream that can begin immediately or in the future. The payouts can be for life or a certain number of years. Annuities are mainly used to provide a steady income during retirement. (For a general overview of annuities, see An Overview Of Annuities.)

Fixed Annuities
A fixed annuity is a written contract offered by an insurance company. It guarantees that you'll make a stated interest rate on your money. This type of investment is risk-free - the insurance company assumes all the risk and guarantees that you'll make the stated interest rate. Fixed annuities are not tied to the stock market in any way.

The following are two subcategories of fixed annuities:

  • Immediate annuities: An immediate annuity, also called a single premium annuity, is when you make a lump sum, or one-time, payment and then a short time later you start receiving monthly, quarterly or yearly annuity payments. These payments can be for life or for a specified number of years. Generally, you buy this type of annuity when you are about to retire or are retired and want to generate a safe, consistent income no matter what.
  • Deferred annuities: You purchase a deferred annuity when you want to build up money on a tax-deferred basis and, at some point in the future, use the money that is invested for your ultimate goals. Some people use deferred annuities as a way to build up for retirement knowing that they will be receiving a guaranteed return no matter what. When you take the money out in the future, you'll owe taxes on the earnings that you made in the annuity.

Generally, you can withdraw up to 10% a year from a fixed annuity without having to pay an early withdrawal penalty. You can easily convert money from a deferred annuity to an immediate annuity. You also can leave the money to a loved one or favorite charity free of estate taxes. Plus, annuities have a 30-day free-look period - if you don't like what the annuity contract says or you simply change your mind, you can return the annuity to the insurance company and receive a full refund.

Variable Annuities
A variable annuity is a contract between you and an insurance company. In this contract, you can make either a lump sum (single) payment or a series of payments. The insurance company agrees to make consistent payments to you immediately or at some date in the future. Variable annuities combine the elements of mutual funds, life insurance and tax deferred retirement savings plans. When you invest in a variable annuity, you can select a variety of mutual funds to invest in.

A variable annuity has two phases:

  • The accumulation phase: During the accumulation phase, you are paying money into the annuity and you have a variety of investment options, ranging from a balanced fund - a type of mutual fund that holds preferred stocks, bonds and common stock to obtain income and growth - to money markets and international funds. The money that you put in the investment options will increase or decrease depending on the funds' performance. The best information you can get about the variable annuity's investment options is the prospectus. This will describe the risks, volatility and whether the fund contributes to the diversification of the investments in the annuity.
  • The payout phase: During the payout phase, you start to receive payments. These payments can be lump sum, or you can have payments sent out to you on a regular basis (monthly, quarterly or annually) for a certain number of years or a lifetime. These payments are guaranteed by the insurance company.

Variable annuities generally provide guarantees that you can't get with other investments. For example, for a fee, you can add a death benefit feature to the variable annuity. Let's say that you invest $125,000 into a variable annuity. A while later, the value of the mutual funds held in the annuity declines to $95,000. Had you put this money into an ordinary mutual fund, you would be down $30,000. With a variable annuity, your beneficiaries will still get $125,000 if you die. In some, if the market value rises to $150,000, your beneficiaries could get a "stepped up" death benefit of $150,000 if you die.

Indexed Annuities
An indexed annuity is a contract between you and an insurance company. With this type of annuity, you can make a one-time payment or a series of payments. The insurance company will credit you the return that is calculated by the changes on a certain index, such as the S&P 500. The insurance company will also guarantee you a minimum return; these minimums can vary from one insurance company to the next.

Here are some of the benefits of an indexed annuity:

  • You can use the funds to build up money on a tax deferred basis (where you pay the taxes once you take the money out).
  • You can take up to 10% a year of the original amount you invested without having a penalty.
  • You can add a death benefit where, if you die early, the annuity will go to your beneficiary and avoid probate altogether.
  • You can also pull out up to 100% of the annuity without penalty if you are forced to go into a nursing home.

Before You Purchase an Annuity
There are several questions that you should ask yourself and an insurance agent to gain a greater understanding of any annuity you are considering.

Ask yourself:

  • What am I going to use this annuity for? If you are retired or nearing retirement and need a consistent income, you may want to consider using a fixed annuity. If you are building up for retirement, you may want to consider a fixed annuity, variable annuity or indexed annuity. If you are going to be leaving your annuity to your children or grandchildren, you may want to take a look at a variable annuity with a death benefit.
  • Am I going to need the money right away? What you really need to know is whether you will need the money in the next two to five years. This is an important factor to consider when you have surrender fees that can affect the principal amount if you take the funds out early.

Ask your insurance agent:

  • What is the minimum guaranteed return? A guaranteed minimum return is a stated return that you will make no matter what. In the case of fixed annuities, they will state the minimum guaranteed return. This will allow you to see what you will make yearly in a worst-case scenario.
  • What are the initial and annual fees paid to the insurance company? In some cases, there are fees paid yearly to the insurance company and there could also be upfront fees that the insurance company will charge. This information is usually found in the prospectus.
  • What are the surrender fees if I get out early? The surrender fee is a cost to you that is paid if you withdraw your funds early. These fees vary from insurance company to insurance company. As a general rule, the longer you hold the annuity the less the surrender fees are. In some cases, these fees disappear completely after a certain number of years.
  • What different types of death benefits are available to me? A death benefit is provided to beneficiaries if you die. This is a stated amount. In some variable annuities, you can use a "stepped up" death benefit (an increase in the benefits). This increase is the result of a rise in the overall portfolio. This will allow you to adjust the death benefit available to your beneficiaries upward.
  • What waivers are available if I need the money right away? A waiver is used when you may need the money for an emergency, such as a medical condition or if you have to go into a nursing home. Many annuities will waive the surrender fee if you need the money for a situation such as this. Before you buy the annuity you need to find out what types of waivers are available.

Conclusion
As you can see, there are several different types of annuities, all with their own benefits. One of the major benefits of an annuity is that it allows you to build up money for retirement, so that when you do retire, you can take a lump sum payment or you can create a consistent income that can last for a certain number of years or for life. You are also able to build up money on a tax-deferred basis.

Some of the drawbacks of investing in annuities include surrender fees that you may have to pay if you need the money early and up-front, and annual fees that may apply. However, you should examine and determine which annuity will work for your situation. This can be done through research and by posing some basic questions, both to yourself and to your insurance advisor.

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