If you’re interested in annuities, finding a simple explanation on what each type is and how the investment earns money can be a bit tricky. Instead of starting with the more complex annuity investments, you may want to familiarize yourself with some of the fundamental characteristics that will apply to the simplest annuity contract as well as the most complex.
Basic Annuity Definition
An annuity investment is essentially a contract between you and a financial institution, such as an insurance company. As is the case with all contracts, both parties have obligations to fulfill in order for the agreement to work. Your obligation with an annuity contract normally requires either an upfront lump-sum payment or a promise to make a number of smaller payments over a specific period of time. In return, the insurance company promises to make payments to you after a number of years -- such as from the time you reach a typical retirement age -- for either a limited duration or for the remainder of your life.
Fixed or Variable
The terms of an annuity contract can be extremely complex, but most may be described as either fixed or variable. A fixed annuity contract will include a guarantee of a certain return on your investment. Other common characteristics include a predetermined rate of interest that your investment will earn, a guaranteed aggregate payout amount and identical payment amounts. Variable annuities provide less consistency and security, often with no guarantee of a minimum return. Their advantage is the possibility that your investment will yield more lucrative returns. This is because the return on a variable annuity depends on market conditions, such as fluctuations in interest rates or in the profitability of companies in which your annuity funds are invested.
Taxation of Annuities
Income tax laws regarding annuity income can be just as complex as the contracts, but some of the basic tax implications may help you evaluate investment options. When you purchase an annuity, the initial cost of the contract is your tax basis. Your payments are not tax deductible at the time you make them, but once the money is inside your annuity, it is allowed to grow tax free. But at some point, you will start receiving periodic payments from the annuity and will need to report them on your tax return. A portion of each payment is considered to be a tax-free return of your initial cost, or tax basis, with the remainder made up of the investment’s earnings, which are taxed as income at the time you receive them. This allocation between earnings and tax basis is reported to you and the IRS on a Form 1099-R by the insurance company each year. If you receive other payments before the date you are to begin receiving regular distributions from the annuity, such as for a dividend or interest, each payment is fully taxable.
Purchasing Annuity Contracts
It’s usually a good idea to purchase an annuity only from a reputable insurance company. Annuities tend to be long-term investments, meaning you might purchase one at age 40 so that you may begin receiving payments when you turn 65. The last thing you want to encounter is an insurance company that’s unable to honor its obligations. Therefore, you should do some research on the company’s credit rating and check with state and federal government agencies that monitor the insurance industry to determine whether the insurance company has ever defaulted on an annuity contract.
Since annuities are intended to be retirement vehicles, withdrawals you take before you turn 59 1/2 will likely face a federal 10 percent tax penalty. In addition, many annuity providers write punishing fees called surrender charges into their contracts to discourage you from leaving the annuity once you enter it. A typical set of surrender charges might charge 10 percent of your investment for abandoning the contract in the first year, 9 percent in the second, 8 percent in the third and so on until the surrender charges finally disappear in the contract's 11th year. If you're not careful, you might still face surrender charges even if you have cleared the 59 1/2 age cutoff that's required to avoid federal fines on your withdrawals.
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