An annuity is an insurance contract that exchanges present contributions for future income payments. Sold by financial services companies, annuities can help reinforce your plan for retirement. Annuity contracts, however, have widely varying terms, and some charge high costs. If you’ve ever wondered what is an annuity, our guide will help you understand the key details so you can decide whether an annuity might be right for your retirement plan.
An annuity can provide you with a predictable stream of income in retirement. The primary benefits of an annuity include:
• Predictable payments: Annuity income payments may be guaranteed for a set period of time or until the end of your life, or the life of your spouse or another beneficiary.
• Tax-deferred growth: Money paid into an annuity grows on a tax deferred basis. When you later receive annuity payments, the earnings portion of your payments is taxed as ordinary income, while principal is generally free of tax.
• Death benefits: Depending on the type of annuity you choose, a named beneficiary can receive payments after you pass away.
A variety of financial companies sell annuities, including insurance companies, banks and investment brokers. After you sign up for an annuity, you begin by making payments to the company, either as a single lump sum deposit or as regular payments over time. The period when you are contributing into your annuity is called the accumulation phase.
In exchange for payments during the accumulation period, the company promises to make regular income payments to you in the future. The period when you start collecting payments from an annuity is called the distribution phase.
You can choose when you want the payments to begin and how long they should last. You could pick a set number of years, like a 10-year payment period, or guaranteed payments for your entire life. Different terms and costs are involved with varying payout periods.
The annuity company calculates how much you’ll receive in future payments using an annuity formula, factoring your account balance and the length of the distribution phase. Then it’s their job to make sure you receive the payments as promised. This is another benefit of an annuity: Less worry about managing investments.
Deferred Annuity vs Immediate Annuity
Under the annuity definition, there are two kinds of contracts, depending on when you start collecting payments. If your payments begin within a year of your purchase, it’s called an immediate annuity. If you’d like to wait a year or longer to start receiving payments, it’s called a deferred annuity.
Either way, the annuity company invests your money in the market so it grows over time. The kinds of investments depend on the type of annuity you choose, which we explain below.
Note that there is a specialized deferred annuity called a qualifying longevity annuity contract (QLAC). You fund a QLAC with a one-time lump sum payment from your IRA accounts or a 401(k) balance, and opt for period payments guaranteed to last for the remainder of your lifespan, starting between when you turn age 72 and age 85.
The longer you wait for your payout, the bigger the payouts become. You may invest up to 25% of the total balance of your IRAs and 401(k)s, or a maximum of $135,000 (whichever is less). family will always come first; you wouldn`t want them to have to bear the financial burden of your last days. No matter what your age, it`s always good to have a plan as to how you intend to cover these costs. Final expense insurance will pay for your funeral service and other associated costs.
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