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Annuity: What Is an Annuity?

These insurance contracts offer steady income but have some downsides

What Is an Annuity?

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

KEY TAKEAWAYS

  • Annuities are insurance contracts that promise to pay you regular income either immediately or in the future.
  • You can buy an annuity with a lump sum or a series of payments.
  • Annuities come in three main varieties—fixed, variable, and indexed—each with its own level of risk and payout potential.
  • The income you receive from an annuity is taxed at regular income tax rates, not long-term capital gains rates, which are usually lower.

Understanding Annuities

The goal of an annuity is to provide a steady stream of income, typically during retirement. Funds accrue on a tax-deferred basis an—like 401(k) contributions—can only be withdrawn without penalty after age 59½.1

The duration of the disbursements can also vary. You can choose to receive payments for a specific period of time, such as 25 years, or for the rest of your life. Of course, securing a lifetime of payments can lower the amount of each check, but it helps ensure that you don’t outlive your assets, which is one of the main selling points of annuities.

Types of Annuities

Annuities come in three main varieties: fixed, variable, and indexed. Each type has its own level of risk and payout potential. Fixed annuities pay out a guaranteed amount. The downside of this predictability is a relatively modest annual return, generally slightly higher than a CD from a bank.

Variable annuities provide an opportunity for a potentially higher return, accompanied by greater risk. In this case, you pick from a menu of mutual funds that go into your personal “sub-account.” Here, your payments in retirement are based on the performance of investments in your sub-account.

Indexed annuities fall somewhere in between when it comes to risk and potential reward. You receive a guaranteed minimum payout, although a portion of your return is tied to the performance of a market index, such as the S&P 500.

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