An annuity is a contract between you and an annuity issuer, usually an insurance company. When you buy one, you're agreeing to pay a certain amount of money to the annuity issuer. In return, the issuer invests your money. Over time, that money earns interest. At a later date, the issuer will pay you back both the principal you invested and all of the interest accrued.
Sounds simple, right?
But there's a lot more that goes into this seemingly simple process.
Let's take a closer look at how an annuity works, step by step. Then, if it's right for you and your financial needs, I can help you add one to your portfolio.
- After you buy an annuity, you send your payment(s) (all at once or over time) to the annuity issuer. These payments are made with after-tax funds, and you may invest an unlimited amount. This is called the "accumulation phase" of your annuity.
- The annuity issuer puts your money in their general account. Your contract specifies how your principal will be returned, as well as what rate(s) of interest you'll earn during the accumulation phase. Your contract will also state what minimum interest rate applies.
- The compounding interest on your annuity accumulates tax deferred. You won't be taxed on these earnings until they are withdrawn or distributed.
- The issuer can collect fees to cover the cost of managing your account (after all, they're doing the work to invest that money to earn the interest they're required to pay you). If you withdraw money in the early years of your annuity, you may also have to pay a surrender fee.
- Your contract may contain a guaranteed death benefit or other provisions for a payout to a beneficiary (spouse, child, etc.) after you pass away.
- If you withdraw money from your annuity before you reach age 59½, you'll not only have to pay tax (at your ordinary income tax rate) on the earnings portion of the withdrawal, but you may also have to pay a 10 percent premature distribution tax, unless an exception applies.
- After age 59½, you can make withdrawals from your annuity without any premature distribution tax. Since annuities have no minimum distribution requirements, you don't have to make any withdrawals (if you're still working, for example, and don't need the money yet). You can let the account grow tax deferred for an indefinite period. However, your annuity contract may specify an age at which you must begin taking income payments.
- When you're ready to retire or just want to start receiving a fixed income stream, you can annuitize. This means you're exchanging your account's cash value for a series of periodic income payments. The amount you get in each payment depends on a number of factors, including the cash value of your account at the time you decide to start taking payments and the payout option you choose. It's also affected by your age and gender, since statistically, these two factors affect how long you'll live - information the annuity provider needs in order to make sure your annuity payments last throughout the rest of your life.
- You'll have to pay taxes (at your ordinary income tax rate) on the earnings portion of any withdrawals or annuitization payments you receive. These funds are invested as part of the general assets of the issuer and are subject to the claims of its creditors. This is why it's important to pick a strong, financially stable annuity provider - and I can help you do just that.