With the cost of living rising steadily, it is important to invest one’s money in financial instruments that secure your future. You may have heard of annuities and wonder how an annuity works. It is basically a contract between an investor and an insurance company, wherein one invests money regularly or in a lump sum, and receives returns immediately or defers them.
There are several advantages to investing in an annuity. First is the fact that you can slowly build up a nest egg and secure your retired years. Putting your money into annuities allows you to create a retirement plan beyond the conventional retirement solutions. Furthermore, there are no limits on the amount that one can invest in such a financial vehicle.
This form of investment is not just great for people who have a long period of employment ahead of them, but also for those who are about to retire. It is a great way to plan one’s estate and by nominating a beneficiary and leave money for your heirs. It also offers a tax advantage as only the money received from pay-outs is taxed.
There are many different types of annuities, and this makes it an ideal investment vehicle for people with varied investment requirements. If you have a large sum of money to invest, you can choose an immediate annuity that would offer a regular source of income for a fixed period of time or for the rest of your life. A deferred investment plan is excellent for people who want to use their investment for tax planning and to postpone the pay-out.
You can also make a choice based on the amount of risk that you are willing to bear. Fixed annuities offer a low and fixed rate of interest. On the other hand, variable ones are linked to the performance of the stock market and they offer a varied rate of interest on your savings. It is important to choose an annuity that suits your financial needs and expectations. Before one is willing to sign on the dotted line, it is crucial to read the details regarding pay-outs, withdrawals and taxation, so that you make an informed and wise choice.
Are Annuities A Good Investment?
Those who are in the process of planning their retirement may find themselves asking the question “Are annuities a good investment?” Annuities are investment products issued by an insurance company and are backed by the company’s financial strength. Annuities provide tax-deferred income growth. When an individual retires, an annuity offers him or her a guaranteed income stream for a specified period. Annuities also provide a buffer against market downturns as they can grow tax-sheltered until the money is withdrawn.
How Do Deferred Annuities Work?
Annuities originally were funded by one lump sum deposit and they began paying monthly installments within one year from the date of that deposit. Today, however, they can be funded over a period of time with smaller deposit amounts and monthly distributions can be deferred for many years. The phase in which money is being deposited into a deferred annuity is called the deferred phase or the accumulation phase. During this period, the funds deposited and the accumulated interest earned is both tax deferred, meaning taxes are not paid on the money until it is distributed from the account.Annuities are commonly used as retirement vehicles and since most people are in a lower tax bracket during retirement, deferring taxes generally results in severely decreased tax obligations. Distributions typically start when the account holder reaches a minimum of 59 ½ years of age, but most contracts also allow for up to 10% of the balance to be withdrawn annually without penalty.
Once the account has reached its contracted maturity, the next phase begins. This is known as the distribution or income phase, as the monthly withdrawals, or distributions, often replace a retirees former income source or pay-check. Several options exist for the timeframe of the distributions. Some people choose annuities that only last for a set number of years. Others choose lifetime annuities. These accounts were developed to provide income for a person’s life, even if the person outlives the account balance. The original design called for any outstanding balances to be abandoned if the person died before the funds were distributed, allowing the funds to revert to the insurance company. Today, most accounts have provisions to leave any undistributed funds to the account holder’s beneficiary of choice.
Interest is earned on deferred annuities in several different methods, depending on the account. Fixed interest rates generally lock in that rate for a specified time period such as one year. Index deferred annuities offer a more conservative choice that offers higher interest rates than fixed accounts. The interest rates on these accounts are tied to an equity index like the Standard & Poor’s 500, which provides more security than variable accounts. To determine the most appropriate and beneficial deferred annuity, an individual should always properly research the available products and rates on the market.
In many ways, annuities function much as Certificates of Deposit (“CDs”) or savings accounts. An initial lump-sum deposit is made into a specialized investment account. Future periodic payments may also be required. The investor allows all funds to remain intact for a pre-specified period of time. Typically, the minimum time period is 5 years; however, it may be as long as 10 years or more.
Expiration of this term is known as “maturity.” At maturity, previously invested funds may be withdrawn or reinvested at your option. Ideally, the investment will have increased substantially by maturity, due to interest earned on all deposits.
Unlike CDs and other liquid investment accounts, an annuity can also serve as a life insurance contract. In addition to investment returns, you receive life insurance covering during the annuity contract term. If you expire before the annuity term does, your heirs receive the face amount of the life insurance policy.
Annuities’ main advantage is tax deferral. Interest earned on invested funds is not taxed until withdrawal. Suppose you are in the 25 percent tax bracket and your average rate of return on a CD is 6 percent annually, you will net only 3.5 percent.
By contrast, Uncle Sam’s hand cannot touch your 6 percent annual annuity returns. Unlike a CD, an annuity is not a liquid financial account.
When you finally settle down and claim your nest egg after a few decades, you may choose how to receive your well-deserved windfall. You may turn the tables and receive monthly income. Uncle Sam’s tax bite is not nearly as bad with relatively small monthly disbursements as opposed to a single mega payoff.
You may even decide to leave the accumulated savings alone and let it become a living legacy for your heirs. The compounded interest remains tax-deferred.
What is better is that your bottom line will be much better for the wear after many years, due to annuities’ historically high investment performance. The paltry returns banks offer on CDs cannot hold a candle to the bright outlook that paves your way to a comfortable retirement with annuity investment.