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What is Annuities?

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

KEY TAKEAWAYS

Annuities are insurance contracts that promise to pay you regular income either immediately or in the future.
You can buy an annuity with a lump sum or a series of payments.
Annuities come in three main varieties—fixed, variable, and indexed—each with its own level of risk and payout potential.
The income you receive from an annuity is taxed at regular income tax rates, not long-term capital gains rates, which are usually lower.

Types of Annuities

Annuities come in three main varieties: fixed, variable, and indexed. Each type has its own level of risk and payout potential.

Fixed annuities pay out a guaranteed amount. The downside of this predictability is a relatively modest annual return, generally slightly higher than a CD from a bank.

Variable annuities provide an opportunity for a potentially higher return, accompanied by greater risk. In this case, you pick from a menu of mutual funds that go into your personal “sub-account.” Here, your payments in retirement are based on the performance of investments in your sub-account.

Indexed annuities fall somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your return is tied to the performance of a market index, such as the S&P 500.

Despite their potential for greater earnings, variable and indexed annuities are often criticized for their relative complexity and their fees. Many annuitants, for example, have to pay steep surrender charges if they need to withdraw their money within the first few years of the contract.

TAX ADVANTAGES

Deferred annuities can also be a good way to help increase your retirement savings. The tax-deferral and compounding of interest provided by an annuity can help it to grow larger than an equal amount placed in a taxable account. Gains will be taxed as ordinary income once the money is withdrawn. Annuities can also be used to fund traditional IRAs, Roth IRAs, and Simplified Employee Pension Plans. When an annuity is used to fund a tax qualified retirement plan or IRA, the tax deferral is provided by the retirement plan or IRA and not the annuity. You should contact your attorney or tax adviser for more complete information.