Annuities can be a wise investment for those looking to secure a steady stream of income in retirement. An annuity is a contract between a purchaser and an insurance company. The purchaser invests in the annuity either via a lump sum premium or a series of payments, and in return, the insurance company makes payments to the purchaser on a future date or series of dates.
If you decide to invest in an annuity, it can be tailored to meet your specific needs. On top of choosing when and how to pay your premiums, you can decide whether you want an immediate annuity, which will start making payments to you right away, or a deferred annuity, which will start making payments in the future. The duration of payments can also vary. You might choose to receive payments for a particular period of time, or until death.
Types of annuities
There are three types of annuities from which to choose:
- Fixed annuities, which pay out a fixed amount.
- Variable annuities, which pay out based on the performance of investments.
- Indexed annuities, which are a hybrid of fixed and variable annuities and pay out a preset amount plus a variable amount depending on the performance of investments.
Benefits and drawbacks of annuities
With an annuity, your money can grow in a tax-deferred fashion. You don't have to pay any taxes on the money you earn until you begin taking withdrawals. Also, unlike other tax-deferred retirement vehicles like IRAs and 401(k) plans, annuities are not subject to annual contribution limits. (For more on IRAs, head to the Fool's IRA Center.) On the other hand, annuities tend to come with high fees, and, like other retirement accounts, they are subject to early withdrawal penalties if you take out money before you reach age 59.5. You can purchase an annuity from an insurance company as you would a life insurance policy.
An IRA annuity is one that is held within an IRA. Just as you can invest your IRA money in stocks or bonds, so too can you use it to purchase an annuity.. There are certain rules that apply to IRA annuities. For example, with an IRA annuity, the balance of the annuity cannot be transferred to another person, though you can transfer an annuity that's already in an IRA of yours into another IRA in your name.
Transferring ownership of a standard annuity, however, can also come with restrictions. If you're looking to transfer a non-qualified annuity (one that is not eligible for tax-deferral benefits) to another person or entity while you're still alive, you may face tax consequences. Earnings on an annuity are typically subject to tax when transferred, and if you transfer an annuity before age 59.5, a 10% early withdrawal penalty may apply.
Furthermore, distributions from an IRA annuity must be taken before April 1 of the year in which the owner reaches the age of 70.5. With non-qualified annuities, there are no required minimum distributions.
Some experts feel that holding an annuity within an IRA is redundant, since both investment vehicles allow money to grow tax-deferred on their own. However, IRA annuities can be useful for those who are behind on their retirement savings and feel the need to catch up, as there are no annual contribution limits. Furthermore, those looking for additional financial security in retirement may wish to use a portion of their IRA money to purchase annuities that guarantee a stream of income.
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