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  • Annuities Explained

    Posted on August 23rd, 2010 William No comments

    One popular option for retirement savings these days is an annuity. There are several types, but they all have one thing in common: you're putting money down now to buy a promise from the insurance company to make regular payments to you at some point in the future. Annuities provide guaranteed income for either a fixed period or for the life of the policyholder.Annuities are regulated by the states, but operate under federal law and may be offered only by life insurance companies. The customer deposits money into the account (either all at once or over some period of time) and then receives interest from that account; this is often called buying an annuity.

    Annuities can be either variable or fixed. In a fixed annuity, the insurance company guarantees that you will earn a certain interest rate, while variable annuities allow you to choose your own investment options. In either case, an annuity is an investment that allows you to defer taxes on growth, as it is not taxed until you begin taking distributions (just like a 401(k)).

    Annuities can also be either immediate or deferred. In the first case, you pay a lump sum and the payments begin immediately (in this case, there is no tax benefit). In a deferred annuity, you can either pay a lump sum up front and the money grows tax free until you retire.

    Annuities are generally used either to cover a need that will exist for a certain number of years, or to provide a guaranteed lifetime income. In the first case,  for example, a grandparent could set up an annuity fund that will provide for a child's needs for the first eighteen years of his life. The latter can be thought of as longevity insurance; it ensures that the bearer will not outlive his retirement savings. (There are also annuities specifically called longevity insurance that do not begin paying until several decades after retirement) The former type is known as an annuity with period certain, while the latter is called a life or lifetime annuity.

    Advantages of an annuity
    The good thing about an annuity is that you can get guaranteed lifetime income, and there is no limit on how much you can contribute or how much you can make, so you can save as much as you want and defer taxes on all of it. You also don't have to worry about outliving your savings, if you have a lifetime annuity sufficient to cover your bills.

    Disadvantages of an annuity
    While your money may grow tax-free, you generally buy an annuity with after-tax dollars, which makes it inferior to a 401(k). It could also be compared to a Roth IRA where you have to pay taxes on your earnings (whereas earnings in a Roth are tax-free, rather than tax-deferred). You also risk losing a good chunk of your investments to commissions and fees, if you're not careful.

    Should you purchase an annuity?
    An annuity is basically a mixture of a 401(k) and Roth IRA (without all the tax advantages provided by either), with a safety net and some profit taken out for the insurance  company. In other words: I won't say not to get one (although Dave Ramsey does say that), but you should probably max out your contribution to your other tax-deferred investment options before considering an annuity.

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