What's an Annuity? How They Work, Benefits & Disadvantages

By Myles Leva

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Last Updated: November 7, 2022

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General investors looking for regular payments have several options. One of those options is investing in annuities.

Annuities are an option if you’re looking for passive income investments that can be tailored to your needs. They aren’t an alternative to or replacement for stocks, bonds, and other instruments. However, they are a common investment for those working towards retiring.

In this article, we will cover:

  • How annuities work
  • Why people invest in them
  • The pros and cons
  • Tax implications

 

 

How does an annuity work?

An annuity is a contract that is issued and guaranteed by an insurance company.

It’s a type of financial instrument that offers guaranteed monthly payments for the duration of the contract. Those payments are consistent and do not change due to market conditions or other factors.

Beyond these basic rules, annuities are a highly customizable type of investment. The investor in an annuity is known as an annuitant.

Annuitants always buy annuities with either a lump-sum payment or through set monthly payments. The institution that provides the annuity then sets up a continuous stream of repayments.

That period can be a set number of years, or simply expire when the investor dies. However, annuities can also be set to be paid out to the investor’s beneficiaries should they die first.

Most investments aren’t able to address the risk the investor has of running out of money and assets during retirement. Often, the risk is simply that the retiree has to make lifestyle sacrifices to be able to continue living off their remaining assets.

This is usually the situation that brings people to purchase annuity contracts from insurance providers.

An annuity contract is an illiquid investment.

The money you put in is intended to remain in the contract, and there are normally heavy withdrawal penalties. This makes them a poor investment for the young and healthy, or anyone else who has less of a need for guarantees and more of a need for growth and/or liquidity.

Upon the activation of a contract, an annuity goes through a few phases.

 

Accumulation

The accumulation phase is the period when the annuity is being funded. During this time, the money in the annuity grows on a tax-deferred basis.

This phase takes place before any payments are sent to the investor.

 

Annuitization

The annuitization phase is when the payments to the investor begin. It is also referred to as the “payout phase”.

At this point, the money that the annuitant saved is paid back. But the size of each payment and the length of time the payments continue will vary. The type of annuity, the specifics of the contract, and its total value all contribute to how much the investor makes back.

 

 

Immediate vs deferred annuity

Annuities can be immediate or deferred.

This is the other major choice general investors need to consider. It’s simply a question of taxes and how they relate to your goals.

Immediate annuities are the simpler kind. You make a one-off, lump sum contribution. That lump sum transaction is then converted into a long-term, guaranteed income stream. The annuitization period can range from a few years to a lifetime. The withdrawals can also begin in just one year.

Immediate annuities are often taken after someone suddenly receives a large amount of money, such as after a lawsuit or inheritance. In those cases, they can be an appropriate and responsible way to handle the situation.

Deferred annuities grow over time on a tax-deferred basis. Annuitization begins according to a date that the investor chooses. That specified time must be after the final premium has been paid.

 

 

Variable or fixed annuities?

Annuities can also be structured to be highly predictable (fixed).

However, variable annuities enable the investor to receive more money if investments in the annuity fund do well. However, the payments can also be smaller if the investments are doing poorly.

 

 

What is the primary reason for buying an annuity?

The main use of annuities is safety in retirement.

Annuities are often invested in specifically for retirement. That’s because they can be used as a cushion against the risk of outliving their retirement savings and other assets.

Beyond that, it’s hard to specify other reasons for taking annuities. That’s because they are a very diverse type of financial instrument that can be approached in different ways.

 

 

Is an annuity a good investment?

If an investor wants a reliable income stream during their retirement, annuities are a good investment.

 

 

What are the disadvantages of annuities?

There are several, but the main one is that they are illiquid.

Regardless of what changes in your life and finances after you invest in an annuity, you can’t touch it without incurring penalties.

Most annuities include a “surrender period” when the annuitant must pay a penalty if any of the money is touched. The actual period can last for just two years, or over a decade. Also, surrender fees can be steep.

These issues may make annuities a poor investment for you, depending on your goals. But of course, you can incorporate annuities as a small part of a larger portfolio as well.

 

 

Do you pay tax on an annuity?

Annuities grow tax deferred. That means you don’t owe income taxes on your annuities’ profits until you:

  • Withdraw funds early
  • Start receiving payments

In this way, annuities are taxed the same way that traditional IRAs are.

IRS Topic 410 goes over pensions and annuities in detail.

 

 

Conclusions

Annuities are an interesting and relatively safe investment option.

They are not normally used as a replacement for stocks and bonds, but they can be used to further diversify your portfolio. The most practical and popular use for annuities is retirement planning.

Photo by Arturo Añez

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