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How Annuities Work

Published April 30, 2014

Annuities are an investment tool that investors use to help plan for retirement. Before deciding whether to make an annuity contract part of your financial plan, it is important to understand how annuities work and what potential pitfalls you need to watch out for.

Annuity contracts are usually made between an investor and a life insurance company. The individual pays a single premium or series of payments at the outset in exchange for a guaranteed distribution or a payout stream determined by the performance of the annuity and underlying investments. An investor can opt to receive payments for a period of time or for the rest of their life. Annuities usually provide tax-deferred earnings growth, and when withdrawals are made, the gains are taxed as ordinary income, not capital gains. Annuities may include a specified minimum death benefit to one’s beneficiary. Early withdrawals may bring tax penalties and surrender charges from the insurance company.

Annuities are generally of three types: fixed, indexed and variable. With a fixed annuity, the insurer promises to pay a specified amount based on the amount in one’s account, and a specified interest rate. The return on an indexed annuity is based on the performance of a stock price index, with a set minimum performance, while a variable annuity allows the investor to choose different options such as mutual funds, with payments based on the performance of those funds.

If you are considering purchasing an annuity product, make sure that you understand the expenses and fees involved. If a high rate of interest is offered, make sure you know whether that is an initial rate intended to make the investment more attractive, which will later drop to a lower rate. And be aware that brokers or agents may push annuities to earn a high commission. High-pressure sales tactics can be a sign that the financial product is a better deal for the seller than for the investor.

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