How does an Annuity Work

An annuity is considered as a perfect insurance product for maintaining a good lifestyle after the retirement. In comparison to other retirement saving plans, annuities offer greater benefits in terms of flexible premium payment option, no contribution limit, higher interest returns, tax advantages and a fixed periodic income. Annuities are also a good saving option for a child's education.

How does an Annuity Work

In general terms, an annuity is a financial contract signed between a financial institution and an annuitant. Usually, the financial institution that sells the annuity product is an insurance company, which is also referred to as an issuer. The annuitant or the person who buys the product is called a buyer. In an annuity contract, the annuitant pays a lump sum money or periodic payments to the insurance company under the condition that the insurance company will provide regular payments to the annuitant immediately or after a specific period.

The term of an annuity plan can be divided into two phases - the accumulation phase and distribution phase. In the accumulation phase, the annuitant deposits money either in lump sum or regular payment to the insurance company. In case of distribution phase, the insurance company pays periodic payments similar to income payments to the annuitant. An annuity plan is often associated with a life insurance component in which a lump sum or periodic payments are made to the beneficiary, in case the buyer dies before getting annuity payments.

The periodic payment by the insurance company to the annuitant is allowed when the buyer completes a specific age. In most cases, the age of the annuitant should complete 59 ½ years, then only withdrawal of periodic money can be done. If withdrawals are made prior to this specific age, certain charges may be applied, for example tax penalties and surrender charges.

Speaking about the charges application, the income tax applied is 10 percent of the deposited or investment money plus regular tax payment rate on the interest returns. The surrender charges are calculated by the insurance company depending upon the withdrawal time and annuity plan. In order to avoid all such circumstances, a buyer should analyze his requirements and the terms and conditions of the annuity plan before buying.

Types of Annuity

There are two major types of annuity, namely, fixed and variable. In the former case, the insurance company assures a fixed interest rate during the period in which the annuitant is accumulating the money. The issuer also guarantees a series of fixed payment for a specific duration (for example, 20 years) or as long as the annuitant's lifetime (or his spouse lifetime).

In variable annuity, the money being accumulated by the annuitant is invested in various plans. The annuitant has the right to choose investment options mostly mutual funds. The interest returns and the amount to periodic payments solely depend on the return on investment (ROI) or performance of the mutual funds that the annuitant has selected. Though a variable annuity involves higher risk, it can also provide high interest rates and periodic payments than a fixed annuity plan.

In addition, annuities can be divided into immediate and deferred types, based on the payout option. An immediate annuity, as name suggests, provides payments to the annuitant immediately; whereas, periodic payments are started in a future date in case of deferred type. Annuity is called a single premium type, if the payment by the annuitant is in lump sum, whereas it is called regular payment annuity, if premium payment is made regularly.