Annuities are flexible financial vehicles designed to pay out a steady stream of income, either right away or at a time in the future. (With some annuities, income may not start for 30 or 40 years.) Annuities represent a contract between you and an insurance carrier – and depending on the type of annuity you have, it could provide you with certain guarantees.
There are two primary categories of annuities. These are immediate and deferred. An immediate annuity can be purchased with a lump sum of money. Often, retirees will “roll” money from a 401(k), IRA (Individual Retirement Account), or other qualified savings vehicle into an immediate annuity so that income can be generated immediately (or within the next 12 months).
Deferred annuities may be purchased with one or more contributions. With a deferred annuity, the income may not be “switched on” until a time in the future – if ever. While funds are in the annuity account, they grow tax-deferred, meaning that there is no tax due on the gain until the time of withdrawal.
The return that is generated on an annuity will often depend on whether the annuity is fixed, indexed, or variable. Fixed annuities generate a set rate of return, and there are no losses incurred in the account – no matter what happens in the stock market. In return for this safety, fixed annuity returns are usually somewhat low.
Fixed indexed annuities are a type of fixed annuity. These financial vehicles generate their return based on the performance of one or more underlying market indexes, such as the S&P 500 and the Dow Jones Industrial Average (DJIA). When the index performs well in a given annuity contract year, a positive return will be credited – usually up to a preset maximum, or “cap.”
In return of this limited upside, fixed indexed annuities keep principal safe because they do not incur losses – even if the underlying index (or indexes) perform poorly in a given contract year. So, fixed indexed annuities are often described as offering a “best of both worlds” scenario.
Variable annuities generate their returns from the performance of underlying equity investments, such as mutual funds. With these annuities, there is often no upside return limit. However, investors can also incur losses if the investments do not perform well. Therefore, it is important to consider both the risk and return potential with a variable annuity.
While annuities can provide many enticing features, they also have a plethora of moving parts. In addition, not all annuities are the same. So, it is important that you understand what certain annuities can and cannot do. Talking over your objectives with a retirement income planning specialist can help what type of annuity – if any – is right for you.
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