What is an Annuity and How Does it Work

The annuities have become one of the most popular investment options of late. They are considered as the best financial arrangement for a comfortable lifestyle, post retirement. Annuities are way more different and beneficial than the rest of the retirement saving plans. They offer a flexible premium payment option, reasonable interest returns, no contribution limit and a fixed periodic income, which plays a huge role in a comfortable life after retirement! Hence, one can say that an annuity is the best means of sustenance for a retiree and the people who are dependent on him.

What is an Annuity?

In simple words, an annuity is a popular insurance products that pays out income as a part of the retirement strategy and acts as a steady source of income after the retirement. This popular type of investment can further be divided into two basic types as the fixed annuities and variable annuities. Understanding the types of annuity is extremely important for you, before you even think of investing your future money in them. A fixed annuity is nothing but an established amount of yearly payment, which is announced by the insurance company. A fixed tax deferred interest is deposited in your account, from which only 10% can be withdrawn. The variable annuity on the other hand, doesn't contain any interest but it rather facilitates you to save the money in the mutual funds.

There is a third option of annuity available which is also called equity index annuity, which pays the interest rate as per the performance of a well-known index, for instance, SP500. Hence, one can say that growth of the index annuity depends on the rate of the stock market. This type of annuity actually helps you get a fixed amount of annuity with a potential of earning profit. Also, there are two major types of the life insurance annuities, which are - immediate annuity and deferred annuity. Wherein, a younger person should opt for a deferred annuity and a retired person can get the immediate annuities.

How Does an Annuity Work?

We need to understand that annuity is a financial contract between the annuitant and the insurance company. The insurance company is called an issuer of the annuity, while the annuitant is called the buyer. During the annuity contract, the buyer pays a lump sum or periodic payment to the issuer with the condition that he will provide him a regular stream of payment within a specific period of time. The annuity term is of two phases, namely, the accumulation phase and the distribution phase. During the accumulation phase, the buyer deposits money through the means of the regular payments or by paying lump sum amount to the issuer. While the distribution phase is the period when the company pays an amount on a previously decided periodic basis.

This stream of regular/periodic payment is allowed only when the buyer passes a specific age limit, mostly 59 ½ years. In case of prior withdrawals, surrender charges and tax deductions might be applicable to the buyer, as the exemption charges. It is important to remember that the interest returns that you get, are a subject to income tax which is 10% of the investment money and the regular payment rate. While the surrender charges are calculated as per the withdrawal time and the specifications of the annuity plan. Hence, it is important for an annuitant to carefully understand the terms and conditions of the insurance company as well as the various pros and cons, before investing money in it.

Knowing how annuities work is very important for you, if you are looking forward to a successful future investment. Every investment requires a thorough planning and detailed analysis and when it comes to the retirement planning, selection of a good annuity plan early on will provide you a comfortable and happy days for the rest of your life!