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One way to think of an annuity is paying someone now to give you an allowance later for retirement.
People buy annuities for various reasons. Annuities are becoming increasingly attractive because so few employers offer old-fashioned, employer-funded pensions. Workers are looking at annuities and other options to create secure sources of income for retirement. Annuities are tax-deferred investments that provide investors incomes for the rest of their lives.
What Is an Annuity?
An annuity is a contract between you and an insurance company in which you pay for a stream of income.
People buy annuities to create long-term income. Unlike other financial investments, annuities are sold, backed and maintained by insurance companies. Annuities are not a good option for short-term investments.
How Annuities Work
An annuity is a contract between an investor and an insurance company that requires the company to make regular payments to the annuity holder starting at a specified time. The investor doesn’t have to pay taxes on the accumulating interest until he or she receives the payments. Many times, with a new annuity contract, you will have a free look period to consider the terms of the contract before everything is finalized.
Getting Annuity Payments
An annuity is a fixed sum of money paid to someone each year, typically for the rest of that person’s life. It is also a form of insurance or investment entitling the investor to a series of annual sums.
What is a Pension?
Once a common benefit, pensions funded by employers offered a guaranteed amount of income retirement. But the plans proved costly for companies under pressure to produce profits. Now it’s more common for private employers to offer 401(k) plans for retirement. Annuities are another option for retirement income.
One of the biggest advantages of an annuity is it allows the investor to save money without paying taxes on the interest until a later date. Annuities have no contribution limits, unlike 401(k)s and IRAs.
Another significant benefit of annuities is they create predictable income streams to fund retirement. With an annuity, you don’t have to worry about outliving your savings. This is a major advantage in the post-pension age.
Disadvantages of Annuities
The main downsides to annuities are twofold. They involve the fact that investor savings are locked down for relatively low payout.
When money is tied up in an annuity, it can’t be used to pay unexpected bills. For this reason, it’s usually not wise to invest all your savings in an annuity. Some of your money should be available to pay unplanned expenses.
The costs of annuities can be prohibitive. Critics say that means the overall return on an annuity investment is paltry compared to other options.
Do Annuities Mature?
In most cases, an annuity doesn’t mature like some other investments, such as bonds. Annuities with life options continue for the annuity holder’s entire life. Some annuities also continue for the life of the annuity holder’s beneficiary. However, some annuities can last for specified times. This will be detailed in the annuity contract.
Do Annuities Have Interest?
Yes. The interest rate and how or whether it changes will be included in your initial annuity contract when you purchase your annuity. The amount will depend on a number of factors, including the type of annuity.
What Are the Types of Annuities?
There are many different types of annuities. They are classified by their terms. Terms can involve anything from when the annuity is paid to how it is purchased. Other terms include how long the payments last and whether it is shared with someone else.
One of the primary ways to classify different types of annuities is how payments to the annuity holder are calculated.
- Fixed annuities guarantee what the payments will be. They preset the principal and minimum interest rate. They are the most predictable for planning your future and carry the least risk. They also may pay at a lower rate than variable annuities. Generally the interest rate on a fixed annuity will be between 1 and 3 percent.
- With a variable annuity, payments to the investor will change based on how their investment portfolio performs. If the portfolio does poorly, the investor gets no or reduced earnings. If the investment does well, the payments go up. This kind of annuity is riskier. But it also has the potential to pay a higher return than a fixed annuity. Some people purchase a variable annuity with what’s called a living benefit income rider. This rider guarantees a certain level of income, eliminating some of the risk of a variable annuity.
- Also known as equity-indexed annuities, indexed annuities combine features of fixed and variable annuities. They carried a guaranteed rate of return, just like fixed annuities. At the same time, they are tied to the performance of a stock market index and allow for higher gains if the stock market does well. Their return varies more than a fixed annuity, but less than variable annuities. These annuities can be difficult to understand and come in a lot of different varieties with different terms. Before you buy an indexed annuity, you should make sure you understand the features of the investment contract.
What is Required Minimum Distribution (RMD)?
Required minimum distribution, or RMD, is the amount of money you are legally required to withdraw from your retirement account on an annual basis. In general, holders of retirement accounts must start making withdrawals when they reach the age of 70 ½.
If you have an annuity held in one of these plans, such as an IRA, it is considered a qualified annuity and you are also subject to the required minimum distribution. Annuity contracts not held in these accounts — considered non-qualified — are not subject to RMDs.
Very few people who win the Powerball lottery elect to take the annuity. The overwhelming majority of winners take lump-sum payments, which are significantly smaller than the announced total jackpot. Experts are split on whether a lump sum or a lottery annuity is better.
Selling an Annuity
Life changes. Medical bills come out of nowhere. You need a new roof. Your old car won’t get you where you need to go anymore. Or, on the good side, you come into money and don’t need the regular annuity payments anymore. You’d rather just have access to your cash.
If you find yourself locked out of your money because it’s tied up in an annuity, there are options. If you need access to the money you have in an annuity, you can sell all or some of your future payments to a third party.
Going this route will save you surrender charges and fees that typically come with premature withdrawals. Annuity.org’s partners can help you get the best deal when selling your annuity.
Reasons for Selling Annuities
There are any number of reasons you might find yourself wanting or needing to sell your annuity.
- Medical Bills
- Home repairs
- Transportation needs
- Helping out a family member
- Paying debt
- Paying for tuition
- Family needs
- No longer need monthly annuity payments
- Investment opportunity
- Annuity doesn’t work for you
It is not uncommon for annuities to be shared or jointly owned between two parties. But just as they can be shared, annuities can also be split. This is a common option for couples going through a divorce, as they choose to split their remaining financial assets and marital property. Splitting an annuity is a complicated process that requires the original annuity contract to be split evenly into two new, identical contracts.
Another concept with a similar name is split-funding an annuity. This is a strategy that combines an annuity that pays immediately with one that has deferred payments.
If splitting an annuity is not an ideal option for you, there is also the option of sell your annuity. In the event that you need cash now, you can sell a portion or all of your annuity payments for a lump sum of cash.
If you want to continue to receive at least some of your annuity payments, you can sell a portion while keeping the tax benefits on the remaining funds. One way to do this is to sell the payments for a portion of your contract. You can select how many years of payments you want to sell and then resume receiving annuity payments after that time passes.
Or you can cash out and sell the right to receive all the future payments, and walk away with a lump sum of money.
Steps to Sell Annuities
There are several steps to selling an annuity. It begins with getting a free quote from a purchasing company and comparing it with offers from other companies. Once you decide which offer to accept, you will receive, review and sign a contract. In most cases, the sale will have to be approved by a judge. The purchasing company will handle most of that. You should also be aware that the sale will likely have tax consequences.
How Much Will I Get?
You should know that the money you receive will be something less than the value of the payments. That’s because the companies that purchase annuity payments are in business to make money. A lot of factors govern how much you will be offered. But it could be anywhere from 50 to 80 percent of the value of the payments.
No matter how you choose to sell your annuity contract, the transaction does require court approval. It is also important to discuss all of your options with a financial advisor prior to making the decision to sell.