When individuals sit down to plan for retirement, it is important for them to consider any and all investment options. The best approach is to develop a plan that creates a steady and secure stream of cash on a monthly basis until death. One of the best ways to achieve this goal would be to purchase an annuity.
An annuity is a contract between two parties where the first party (purchaser) submits a lump sum payment or periodic payments to a second party (issuer) who agrees to make monthly payments back to the purchaser. Those monthly payments come in the form of annualized earned income from the annuity. The issuer of the annuity agrees to a minimum guaranteed rate of return establishing a minimum monthly minimum payment amount.
Characteristics of an Annuity
The two most common issuers of annuities are insurance companies and non-profit organizations such as major charities. Annuities can be purchased on a deferred tax or after tax basis, depending on the purchasers personal goals. Earnings are always tax deferred until withdrawn. Those earnings are then taxed at ordinary rates instead of capital gains rates, which are usually applied to investment income. Annuities can have a fixed term or be designated “until death”.
Types of Annuities
According to the U.S. Securities and Exchange Commission, there are three primary types of annuities.
- Fixed Annuity – The issuer agrees to pay a stated fixed rate of return for the duration of the contract.
- Indexed Annuity – The issuer agrees to pay a rate of return based on a specific financial index as determined by the contract.
- Variable Annuity – The issuer agrees to allows the purchaser to invest the annuity amount in a variety of limited investment options. This gives the purchaser some level of control over potential earnings.
How Does an Annuity Work?
Example: An fixed annuity contract is written between a purchaser and issuer where the purchaser agrees to give the issuer a $200,000 lump sum payment for a 5% annuity until death. The issuer will be required to send the purchaser a monthly amount of $833.33 ($200,000 times 5% divided by 12 months) until the purchaser passes away.
Advantages of Annuities
- Death Benefits – When annuities are purchased from insurance companies, they can be written to include a death benefit. The death benefit usually equates to some portion of the annuity based on how long the annuity contract has been in effect.
- Steady Cash Flow – Annuities provide a reliable cash flow. This works out quite well for individuals who are good at budgeting and managing money.
- Tax Advantages – Annuities purchased from some non-profit organizations are tax deductible based on IRS guidelinee, just like any other charitable contribution. Also, taxes on earnings are deferred until the payments are issued.
Disadvantages of Annuities
- Financial Stability of the Issuer – If the issuing company or organization should happen to fail, some portion of the annuity will be lost with no recourse.
- Premature Death – Should the purchaser die too early into the annuity contract, the remaining annuity won’t be eligible for inheritance, resulting is a significant loss.
- Early Withdraw – If the purchaser needs to terminate the annuity prior to the contact’s expiration, they will be subject to substantial forfeiture fees.
In most cases, annuities offer a solid retirement type investment. It is incumbent on the purchaser to understand, how do annuities work? Also, they need to perform proper due diligence on the issuing organization in order to determine the company’s economic strength. Finally, the purchaser should take the time to shop for the most advantages annuity contracts.