An annuity is an insurance product that pays out income, and can be used as part of a retirement strategy. Annuities are a popular choice for investors who want to receive a steady income stream in retirement. Here’s how an annuity works: you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment. The size of your payments is determined by a variety of factors, including the length of your payment period. You can opt to receive payments for the rest of your life, or for a set number of years. How much you receive depends on whether you opt for a guaranteed payout (fixed annuity) or a payout stream determined by the performance of your annuity’s underlying investments (variable annuity).
Advantages
There are two basic types of annuities: deferred and immediate. With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically in retirement. If you opt for an immediate annuity you begin to receive payments soon after you make your initial investment. For example, you might consider purchasing an immediate annuity as you approach retirement age. The deferred annuity accumulates money while the immediate annuity pays out. Deferred annuities can also be converted into immediate annuities when the owner wants to start collecting payments. Within these two categories, annuities can also be either fixed or variable depending on whether the payout is a fixed sum, tied to the performance of the overall market or group of investments, or a combination of the two.
The biggest advantages annuities offer is that they allow you to sock away a larger amount of cash and defer paying taxes. Unlike other tax-deferred retirement accounts such as 401(k)s and IRAs, there is no annual contribution limit for an annuity. That allows you to put away more money for retirement, and is particularly useful for those that are closest to retirement age and need to catch up. All the money you invest compounds year after year without any tax bill from Uncle Sam. That ability to keep every dollar invested working for you can be a big advantage over taxable investments. When you cash out, you can choose to take a lump-sum payment from your annuity, but many retirees prefer to set up guaranteed payments for a specific length of time or the rest of your life, providing a steady stream of income. The annuity serves as a complement to other retirement income sources, such as Social Security and pension plans.