What Are Annuities? - Understanding The Basics

When it comes to annuities, some find them to be complex financial products. While in many cases this is true, it's not so difficult to understand the basics of how they work and what they can do for you.

What is an Annuity?
An annuity is an agreement between its owner and an insurance provider. In return for the money which has been paid in its account, the provider will repay the money back in intervals, plus interest. In other words, this is a financial product that structures your savings so that you will be provided with income for a prolonged period, which may be particularly useful in retirement.

Types of Annuities
There are several different types of annuities, including those received from Immediate, lottery winnings, pensions, or a deferred annuity. An immediate (single premium) is most often used with retirees looking for a way to turn a sum of money into a monthly income. Annuities are used in lottery winnings, where a lump sum is translated into years of systematic income. Pension plans are a periodic income source based on the amount of money put into the account and/or the amount of time an owner was with an employee. A deferred annuity is a system that holds off payments until the recipient has built up a nice chunk of tax-deferred earnings. The payments of these can be given out as either periodic, annuitization, or a lump sum.

Annuities began from the humble idea of having a way for corporations to offer investment products to their employees. Under these same rules, anyone can have an annuity, so long as you are able to pay money into an annuity account. As this account grows, the recipient is motivated by the idea that it will one day serve as a guaranteed source of periodic income. Today's annuities are not just guaranteed income streams, but can also be tailored to fit your individual needs, including offering guarantees against loss and survivor options.

Structured Settlements
Annuities have worked out so well over the years, it was obvious that this system would one day be used in lawsuits to help a plaintiff collect a lump sum that would then be given in the form of periodic payments through a third party. Structured settlement payments are a safe way for a large sum of money to become guaranteed income for a period of years, or even a lifetime. Structured settlements are most often used is cases where money is awarded for an injury or wrongful death, such as a workers compensation case. They are also used as the payment plan in state lottery winnings.

Pros & Cons of Annuities
As you can imagine, there are pros and cons to collecting and receiving your earnings through an annuity. Many people use annuities because they offer a safe means to collect their nest egg (most insurance companies offer a guarantee against loss), and watch their money grow under a tax shelter. This is a nest egg that will eventually become a form of periodic income that may replace other forms of income or assets that are not guaranteed (job, home, business, etc.). The cons of an annuity are that your money is fundamentally locked away for a certain period of time. In some cases, if those funds are withdrawn before age 59.5, you will be penalized by the IRS. By agreeing to an annuity, you relinquish the option to collect that money as a lump sum payment. An annuity payment allows your nest egg to maintain its value through inflation. However, it still requires an assortment of administrative fees and commissions that will ultimately take away from your savings.

Annuities are structured for your best interest during the time that they are set up. Unfortunately, rarely does anyone's life go unchanged, so it is likely that one day an annuity holder will need to sell a portion or all of their scheduled payments, in order to pay for a bill or debt. On some occasions, an owner may want to sell in order to fund an opportunity or chapter in their life, such as a new business or child's tuition. How much of a lump sum you will receive will depend on the estimate of your annuity.

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