Chapter 3-1-Introduction to Annuities
An annuity is a contract between you and an insurance company. The company agrees to make regular payments to you, beginning either right away or at a future time. If the payments are put off to the future, you have a deferred annuity. If the payments begin right away, you have an immediate annuity. You purchase the annuity with an individual payment or an arrangement of payments referred to as premiums. Annuities generally provide tax-deferred growth of profits and may contain a death benefit that will compensate your beneficiary an assured minimum total, such as your total purchase payments.
The contributions made to annuities are not tax deductible, however the taxes on gains are deferred until the money is taken out. There is a 10 percent penalty for withdrawing the money prior to turning 59 ½ years of age and withdrawals must start by 70 ½ years of age. After the money is withdrawn, it is taxed as regular income, not as capital gains. There is no restriction on how much money can be deposited into an annuity. 401k plans as well as traditional IRAs are bankrolled with pre tax money. In contrast, the annuity is bankrolled with post tax money. Because you are not paying taxes on the gains in an annuity, more of your capital is making money each year than if the taxes were taken out each year. This significantly increases the rate of return over time.
There are two kinds of annuities, fixed and variable. In a fixed annuity the insurance company guarantees the rate of return as well as the principal contributed. In contrast, a variable annuities rate of return is not fixed, but varies with the performance of the stock, bond, and money market investment alternatives that you select. There is no certainty that you will get any return on your investment and there is also a risk that you may lose money. Different from fixed contracts, variable annuities are securities registered with the Securities and Exchange Commission (SEC).
With a fixed annuity, the insurance company ensures that you will get a minimum rate of interest at the time that your account is increasing. The insurance company also ensures that the fixed payments will be a guaranteed total per dollar in your account. These fixed payments can last for a specified time, like 20 years, or an undetermined time, like your life span or the life span of you and your spouse.
In a fixed annuity, the insurance company invests the gains in fixed rate investments like bonds. You make a guaranteed fixed rate of return for a predetermined length of time. When this time is finished, your assets are rolled into a new time cycle at a new rate. The new rate may be either favorable or unfavorable based on economic conditions. In numerous fixed annuities, there will be a guaranteed minimum rate which is frequently connected to the rate of treasury bills. In a fixed annuity, the insurance company is assuming the investment risk.
Variable annuities differ completely from fixed annuities. With a variable annuity, you can decide to invest your purchase payments amongst a spectrum of various investment alternatives, often in mutual funds. The rate of return on your purchase payments, and the total of the fixed payments you will receive in the long run, will differ based on the performance of the investment alternatives that you have chosen. In a variable annuity, your gains are invested in stocks, bonds, mutual funds, money markets, and even real estate. Numerous mutual funds are part of a family of funds, and the investor can move funds between components of the fund family without taking on additional fees. The owner of the annuity may have the alternative to move the assets in the annuity among different investments as well. Consequently, in a deferred variable annuity, the total money made throughout the accumulation period can differ significantly based on the performance of the investments.
The payout of the variable annuity is dependent on the amount of units retained by the owner of the annuity. A unit is similar to a share in a mutual fund. You own a specific number of shares in a mutual fund but the total of the share changes. You are assigned with a number of units, but the total of those units will change producing a variable payout. Unlike a fixed annuity, in a variable annuity the risk is assumed by the owner of the annuity.
The assets for a fixed annuity are retained by the insurance company in a common account. The assets for a variable annuity are retained in an individual account for the owner of the annuity. Numerous variable annuity contracts permit a combination of fixed and variable with a number of assets retained in the common account and others in the individual account.