A:

An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future.

The goal of annuities is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.

Many aspects of an annuity can be tailored to the specific needs of the recipient. In addition to choosing between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions - that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while those that start at a preset date in the future are called deferred annuities.

The duration of the disbursements can also vary. You can choose to receive payments for a specific period of time - for example, 25 years - or obtain them until your death. Of course, securing a lifetime of payments lowers the amount of each check, but it helps ensure that you don't outlive your assets.

Annuities come in three main varieties - fixed, variable and indexed - that each have their own level of risk and payout potential. Fixed annuities pay out a guaranteed amount based on the balance of your account. The downside of this predictability is a modest annual return, generally slightly higher than a CD.

You have the opportunity for a higher return, accompanied by greater risk, with a variable annuity. In this case, you pick from a menu of mutual funds that comprise your personal "subaccount." Here, your payments in retirement are based on the performance of investments in your subaccount.

Indexed annuities are somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your disbursements is tied to the performance of a market index, such as the S&P 500.

Despite their potential for greater earnings, variable and indexed annuities are sometimes criticized for their fees and their relative complexity. For example, many annuitants find that they have to pay steep surrender charges if they try to get their money out within the first few years of the contract.

An important feature to consider with any annuity is its tax treatment. While your balance grows tax-free, disbursements are subject to income tax. Conversely, mutual funds that you hold for over a year are taxed at the long-term capital gains rate. And unlike 401(k) accounts, contributions to annuities don't reduce your taxable income. For this reason, some finance experts recommend annuities only after maximizing your contributions to pretax retirement accounts.

RELATED FAQS
  1. For what types of financial instruments would I want to calculate the present value ...

    Learn about the types of financial instruments the present value of an annuity calculation is most useful for, including ... Read Answer >>
  2. What are the risks of annuities in a recession?

    Distinguish between the most common types of annuities, and understand which types of annuities pose the most risk during ... Read Answer >>
  3. What is the difference between a fixed and variable annuity?

    Understand the difference between fixed, variable and indexed annuities, and read a brief summary of their respective risks ... Read Answer >>
  4. What are the risks of rolling my 401(k) into an annuity?

    Learn about risks to consider before rolling over your 401(k) into an annuity, including increased fees and the risk of forfeiting ... Read Answer >>
Related Articles
  1. Retirement

    How a Fixed Annuity Works After Retirement

    These popular investments can provide a steady stream of income during your retirement years. Here are the details.
  2. Financial Advisor

    An Overview Of Annuities

    These contracts provide a guaranteed income stream. Learn how they work and their benefits.
  3. Retirement

    Annuities: How To Find The Right One For You

    Fixed, variable and indexed annuities offer different features. Find out which one fits your needs.
  4. Retirement

    How a Variable Annuity Works After Retirement

    These investments can provide extra income after you retire. Here’s a guide to when and how you will receive the payout.
  5. Retirement

    Are Annuities Retirement-Only Investments?

    Learn more about why annuities are generally purchased and the way that they can positively and negatively affect an individual preparing for retirement.
  6. Retirement

    What Role Should Annuities Play in Retirement?

    Fixed annuities can provide income protection for those worried about outliving their assets. But don't buy a bigger policy than you really need.
  7. Financial Advisor

    Annuities: The Good, Bad and the Ugly

    Annuities suffer from a few perception problems. This primer that covers the good, the bad and the ugly of annuities.
  8. Retirement

    Who Benefits From Retirement Annuities

    Annuities guarantee some degree of fixed income in retirement. But is the security worth the fees and less favorable tax treatment? How to decide.
  9. Retirement

    Retirement Tips: Choose the Best Annuity Provider

    It pays to get the best advice if you are thinking of putting your money into one of these complicated investments.
  10. Retirement

    Why Are Annuities Important for Retirement?

    Understand how annuities work, and identify the benefits they provide for retirement, the most salient being a guaranteed income stream for life.
RELATED TERMS
  1. Annuity

    A financial product that pays out a fixed stream of payments ...
  2. Deferred Payment Annuity

    An annuity where the payments received will start some time in ...
  3. Valuation Period

    The time between the end of the business day of the first business ...
  4. Annuity Consideration

    The money that an individual pays to an insurance company in ...
  5. Variable Annuity

    An insurance contract in which, at the end of the accumulation ...
  6. Secondary Market Annuity

    A secondary market annuity (SMA) is a transaction in which the ...
Hot Definitions
  1. IRS Publication 970

    A document published by the Internal Revenue Service (IRS) that provides information on tax benefits available to students ...
  2. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  3. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  4. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  5. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  6. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
Trading Center