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.
As an investment, an annuity provides a guaranteed income stream of future payments. It allows individuals to create a tax-deferred nest egg for retirement to provide funds later in life.
Annuities were created from the idea of having a way for corporations to provide investment products to their employees. This was based on the idea that as an account grows, it the employee by the idea that a guaranteed source of periodic income will be there for them later in life, and offer incentive. Nowadays, an annuity is more than a guaranteed income stream. but can also be customized to fit individual needs, including guarantees against loss and options for a surviving spouse.
Types of Annuities
There are several different types of annuities, including those received from an immediate or deferred, lottery winnings, pensions, and structured settlements.
Immediate Annuity (single premium) - This annuity is most often used with retirees looking for a way to turn a sum of money into a monthly income. An immediate annuity can provide periodic payments as a fixed period or for the duration of life for you or your spouse. These payments can be monthly, quarterly or annuially and provided based on your principal and earnings accrued. As with most annuities, an immediate annuity has tax deferred growth. Some of the drawbacks of this type include fees and lack of flexibility.
Deferred Annuity - This is a system that holds off payments until the recipient has built up a substaintial amount of tax-deferred earnings. The payments of this annuity can be given out as either periodic, annuitization, or a lump sum. Benefits of deferred annuities include no contribution limits (unlike IRA’s), guarantees against loss, and lifetime benefits. However, they do lack liquidity, come with high cost fees, Additionally, unlike investments like stocks, bonds and mutual funds which receive lower capital gains rates, a deferred annuity is charged at your ordinary income tax rate.
Lottery Winnings - Annuities for lottery winnings are used where a lump sum is translated into years of systematic income. While many prefer the stream of future payments, when you consider the time value of money its often more beneficial to take a lump sum. The most significant advantage to accepting a long-term payout is the benefit of tax-deferred payments.
Pensions - These are plans provided by private companies, federal/state/local governments, military and organizations where 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. Concerns surrounding this type of annuity include inflation and how the how the time value of money affects the annuity, and the possibility of insolvency of the sponsor or povider.
Structured Settlement Annuity - This is a periodic payment provided as compensation, most commonly for personal injury, workers’ compensation claims or wrongful death. A settlement annuity provides guaranteed payments that are not affected by fluctuations of financial markets and exempt from federal, state and local taxes. But they don’t offer much flexibility once terms are finanalized and the funds are locked into periodic payments.
Since annuities have worked out so well in the past, it was apparent that they would one day be used in lawsuits to collect a lump sum that would then be provided as periodic payments. Structured settlement payments provide a risk-free option for a large sum of money to become guaranteed income for a period of years for the recipient. They’re are most often used is cases where amount is awarded for personal injury, wrongful death, or as a workers compensation case. They are also provided as a form of payment for lottery winnings. In some cases, the recipient of structured settlements are minors, which is either preserved until they reach legal adulthood or a court assigned guardian or trustee is provided for financial security.
Selling Annuity Payments
Sometimes life can interupt and financial plans change, requiring access to funds for unexpected expenses and selling an annuity can provide the financial assistance needed. Before making such decisions it’s always advised to analyze all options before selling. While receiving a lump sum, you are giving up a stream of future payments. It’s important to understand that a discounted rate is applied when doing so, as the future holder of these payments must lock in their finances until the end of the term to recoup their investment. It’s this discounted rate that creates a secondary market for annuities, and without it their wouldn’t be investors available to buy annuities, settlements, or lottery winnings.
Recommended reading: How much is my settlement worth?
Pros & Cons of Annuities
It probably comes as no surprise that there are pros and cons an annuity. Many use annuities because they’re foten considered a safe option to growing their nest egg, and allow one to watch their money grow under a tax shelter. This is a nest egg that will eventually provide a periodic income that can replace other forms of regular income or assets that might not be guaranteed.
The negative aspects of an annuity are that your money is unavailable for a pre-determined amount of time. In cases where funds from an annuity are withdrawn before age 59.5 you will be penalized by the IRS. By agreeing to an annuity, you forfeit the ability to collect that money as a lump sum payment. An annuity payment allows your retirement savings to maintain its value through inflation. However, it still comes with various administrative fees and commissions that eat away at your savings.
Annuities are created and structured in a way that’s in your best interest during the time that they are originaly set up. Unfortunately, since it’s rare that anyone's life goes unchanged later, it’s likely that someday the annuity holder will need to sell part of or all of their scheduled payments for one reason or another. There are occasions where an annuity owner may want to sell in order to fund an opportunity to make changes in their life, from starting a new business or paying for a child's tuition to other circumstances out of necessity such as paying down debt or taking care of unexpected expenses.