There are many ways to save for and fund retirement, including annuities. If you have an annuity and want to better understand how they work, or you're considering one to help stretch your savings, read on to learn about this particular retirement tool.
Overview
What is an annuity?
An annuity is a type of financial product that's issued and distributed by an insurance company. Although you fund it like an account, there's a contract involved that explains how the insurance company is going to pay your money back out to you.
These funds are used for retirees who are afraid they may run out of savings before the end of their lives. They guarantee an income stream for either a fixed period of time or for the rest of the holder's life.
Types of annuities
Types of annuities
There are many types of annuities, but these are the most common:
- Fixed period annuities. Fixed period annuities pay a regular, fixed amount of money to the recipient for a specified period of time.
- Variable annuities. These annuities pay variable amounts to the recipient either for a specified period of time or for the life of the recipient. Payment varies based on how much the annuity earns, and may also be influenced by cost-of-living indexes.
- Single life annuities. Single life annuities pay a fixed amount of money at regular intervals during a single owner's life, and end at their death.
- Joint and survivor annuities. This type of annuity is designed to provide for a surviving spouse or partner, as it continues to pay a second person after the original recipient dies. The survivor's benefit may be the same or different from that of the originator of the annuity.
- Qualified employee annuities. Qualified employee annuities are purchased by an employer on behalf of their employees.
- Tax-sheltered annuities. Employees of public schools or other tax-exempt organizations may have these special annuities purchased on their behalf.
How they work
How do annuities work?
Annuities have two phases: the accumulation phase and the payout phase. These are pretty much exactly what you might imagine. During the accumulation phase, you're building up your annuity so it has enough funds to pay back out later down the line, during the payout phase. Every contribution you make to your annuity is tax-free; you only pay taxes once you start to withdraw funds.
During the payout phase, your annuity will start to send you payments based on the type of annuity you have and the agreement you signed. It may pay monthly for life, or quarterly for a set amount of time, depending on your agreement. Payments can be fixed or variable. This is why it's very important to understand what kind of annuity you're getting into.
Related investing topics
Importance to investors
Why stock investors should understand annuities
Although having a strong stock portfolio will take you far, it's important to look at other kinds of investments that are safe, will hold their value, and can help even out your income over time.
Annuities are one such tool, and can hedge against periodic losses in the market that happen as sentiment ebbs and flows. They also grow tax-deferred, so what you put in grows a little bit bigger through the power of compounding before you have to give your part to the IRS when you make your withdrawals.
Just like it's important to diversify your stock portfolio, it's also important to diversify your types of investment tools. This helps prevent any kind of upset that might come from having all your eggs in just one financial basket.
