What is an Annuity?

What is an AnnuityThere are many different types of financial products an individual can use to accumulate wealth to use during their retirement. IRAs, 401(k)s and traditional brokerage investing accounts usually comprise the backbone of most individuals’ retirement savings plans. But this is not a complete list of options that are available. One lesser known retirement savings product is the annuity.

Annuity Basics. Unlike investing in stocks or mutual funds or bonds, an annuity is actually a contract between an individual and a life insurance company. The basic structure of an annuity contract is for the individual to make one or more payments to the insurance company, in exchange for which the insurance company agrees to make periodic payments to the individual who purchased the annuity.

  • Immediate Annuities. Immediate annuities are the type of annuities most people may already be familiar with. An immediate annuity is one in which the beneficiary makes a single payment to the annuity company, and the company immediately begins making periodic (usually monthly) payments to the beneficiary. The most common type of immediate annuity is one in which the beneficiary will receive payments for the remainder of his or her life.
  • Annuity Beneficiaries. Some annuity contracts contain provisions under which a named beneficiary will receive certain financial benefits if they primary annuity owner passes away before receiving a certain amount of benefits. In these situations, the named beneficiary will generally receive a lump-sum payment or a series of payments over a fixed period of time.
  • Deferred Annuities Distinguished. Another type of annuity is known as a deferred annuity. Under a deferred annuity contract the annuity owner will make payments to the annuity company over time, but not begin to receive payments back until a date in the future. Because the payments to the annuity company do not need to be made all at once, this can be a more affordable and manageable option for some individuals.

    • Why You Might Consider an Annuity. Annuity contracts come with certain types of tax benefits, and can therefore be a good tax planning (and even estate planning) tool. Furthermore, because the annuity owner knows exactly how much they have to pay to receive a specified income stream in the future, purchasing and annuity can remove much of the uncertainty that comes with making one’s own investment decisions. Of course, the converse is also true since purchasing an annuity contract limits the long-term upside of an individual who makes good investment decisions.

    What You Need to Know About Annuities. It’s important to understand that annuities are simply a contractual right, not an “asset” in the same way as a stock would be. As a contract, any potential purchaser needs to fully understand the terms of any particular annuity they are considering buying. For example, some annuities can be pledged as collateral for loans, while others may not. For individuals who are seeking certainty in their retirement planning, and who are willing to trade the potential for larger investment gains, annuities may be a good solution.

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