First of all: What is an Annuity?

An annuity is an insurance product that pays out income, and can be used as part of a retirement strategy. Annuities are a popular choice for investors who want to receive a steady income stream in retirement.

Secondly: How does it work?

Here's how an annuity works: you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. The income you receive from an annuity can be doled out monthly, quarterly, annually or even in a lump sum payment. The size of your payments is determined by a variety of factors, including the length of your payment period. You can opt to receive payments for the rest of your life, or for a set number of years. How much you receive depends on whether you opt for a guaranteed payout (fixed annuity) or a payout stream determined by the performance of your annuity's underlying investments (variable annuity).

 What are the different types of annuities? 

There are TWO basic types of annuities: Deferred and Immediate.

• Deferred explained.

  • With a deferred annuity, your money is invested for a period of time until you are ready to begin taking withdrawals, typically in retirement.

• Immediate explained.

  • If you opt for an immediate annuity you begin to receive payments soon after you make your initial investment. For example, you might consider purchasing an immediate annuity as you approach retirement age.

• Deferred vs. Immediate.

  • The deferred annuity accumulates money while the immediate annuity pays out. 

  • Deferred annuities can also be converted into immediate annuities when the owner wants to start collecting payments.

• Fixed vs. Variable

  • Within these two categories, annuities can also be either fixed or variable depending on whether the payout is a fixed sum, tied to the performance of the overall market or group of investments, or a combination of the two.

Generally: What are the benefits?

• Money that you invest in an annuity grows tax-deferred. When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.

• The biggest advantages annuities offer is that they allow you to sock away a larger amount of cash and defer paying taxes.

• Unlike other tax-deferred retirement accounts such as 401(k)s and IRAs, there is no annual contribution limit for an annuity. That allows you to put away more money for retirement, and is particularly useful for those that are closest to retirement age and need to catch up. All the money you invest compounds year after year without any tax bill from Uncle Sam. That ability to keep every dollar invested working for you can be a big advantage over taxable investments.

• When you cash out, you can choose to take a lump-sum payment from your annuity, but many retirees prefer to set up guaranteed payments for a specific length of time or the rest of your life, providing a steady stream of income.

• The annuity serves as a complement to other retirement income sources, such as Social Security and pension plans.

Do annuities have any investment options?

• It depends on which type of annuity you have. If you choose a fixed-rate annuity, you are not responsible for choosing the investments - the insurance company handles that job and agrees to pay you a pre-determined fixed return.

• When you opt for a variable annuity, you decide how to invest your money in the sub-accounts (essentially mutual funds) offered within the annuity. The value of your account depends on the performance of the funds you choose. While a variable annuity has the benefit of tax-deferred growth, its annual expenses are likely to be much higher than the expenses on regular mutual funds - so ordinary funds may be a better option.

What payout options do I have?

• When you invest in your annuity you also choose how you want your eventual payouts to be calculated. Your options include:

  • Income for guaranteed period (also called period certain annuity). You are guaranteed a specific payment amount for a set period of time (say, five years or 30 years). If you die before the end of the period your beneficiary will receive the remainder of the payments for the guaranteed period.

  • Lifetime payments. A guaranteed income payout during your lifetime only; there is no survivor benefit. The payouts can be fixed or variable. The amount of the payout is determined by how much you invest and your life expectancy. At the time of death all payments stop - your heirs don't get anything.

  • Income for life with a guaranteed period certain benefit (also called life with period certain). This is a combination of a life annuity and a period certain annuity. You receive a guaranteed payout for life that includes a period certain phase. If you die during the period certain phase of the account, your beneficiary will continue to receive the payment for the remainder of the period. For example, life with a 10-year period certain is a common arrangement. If you die five years after you begin collecting, the payments continue to your survivor for five more years.

  • Joint and survivor annuity. Your beneficiary will continue to receive payouts for the rest of his or her life after you die. A popular option for married couples.

What happens to my annuity after I die?

• It depends on the type of annuity and how your payouts are calculated. There are several different methods. You do have the option of naming a beneficiary on your annuity, and with certain types of payout options that beneficially could receive the money in your annuity when you die. Other options just pay out during your lifetime, and the payments stop when you die.