What Is An Annuity And Why Would I Want One?

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If you’ve never had someone try to sell you an annuity, you’re either lucky or young. As you near retirement, you will have a plethora of “financial advisors” offering you annuities as the solution to your every financial need. Because of this, it’s important for you to understand what they are and when you would want one.

 

How Annuities Work

An annuity is a form of insurance, though often called an investment, that entitles the owner to a series of annual payments. Basically, you pay an insurance company a lump sum upfront, and then they send you regular annual payments later.

 

The payments can either be for a specified period of time or for the rest of your life. Usually, annuities include a death benefit where your beneficiary receives the value of your annuity or a guaranteed minimum.

 

Different Kinds Of Annuities

There are a number of different kinds of annuities. Some of the terms you will come across are:

 

  • Immediate Annuity. These begin making payments to you immediately or within one year.

 

  • Deferred Annuity. These begin paying out at a specified time in the future.

 

  • Fixed Annuity. With these, your principal is fixed by the insurance company, as are your gains. You are guaranteed a certain amount of money. These are also called Multi-Year Guarantee Annuities, or MYGA.

 

  • Variable Annuity. The funds for these annuities are invested into mutual funds and grow or shrink with the underlying investments. They offer more opportunity for growth than fixed annuities but also run the risk of losing money.

 

  • Fixed-Indexed Annuity. These grow at the greater of either a fixed annual rate of return or the return on a specific market index.

 

  • Riders. Like with other insurance policies, you can add different riders to annuities. Some include a guaranteed rate of return for variable annuities or a long-term care provision.

 

Why People Buy Annuities

So why do people buy annuities? Because they want a guaranteed income stream, usually for retirement.

 

Why not put the money in a savings account and make yourself regular payments? Well, usually you can get a higher rate of return with an annuity because the insurance company is earning money off of your money in the meantime.

 

Why not invest your money in stocks and make regular withdrawals? While you can earn much greater returns in the stock market, there is usually more risk involved. People like annuities because they want something certain and guaranteed.

 

What To Know Before Buying An Annuity

There is something very important you need to understand about annuities. While people refer to them as investments, they are actually insurance products. Why does this matter?

 

People who sell you investments, such as stocks and bonds, are regulated by the Securities & Exchange Commission or their state. There are a lot of rules that they must follow about what they can and can’t do and say. Insurance salesmen (those who sell annuities) are not regulated in the same way and are not required to act in your best interest.

 

People who sell annuities make their living off of commissions from those sales. That means that what is best for the salesman may not be what is best for you. Unless you have complete confidence in the salesman and their character, you should always seek an unbiased professional opinion before purchasing an annuity.

 

When purchasing, you need to make sure you understand the fees involved and the tax implications. Many annuities are taxed as regular income instead of at the lower long-term capital gains rates. Variable annuity fees average 3.5%, more than double the average mutual fund fee. They also have yearly contract charges and fees for taking your money out early.

 

If you’re considering buying an annuity or wondering what to do with one you already have, you should consult a professional financial planner well-versed in annuities. Talk to a knowledgeable person that doesn’t stand to gain anything. This is your hard-earned money, so do what it takes to make sure you’re making a wise decision.

 

And remember, as with anything, if you don’t understand it, don’t buy it.

 

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