Annuity Definition and How They Work
Life annuities are confusing for most people. There are many different types and all are basically the same thing: a product where an insurer makes payments to the insured for the term of their life. The seller is also known as the issuer. These payments to the buyer (also known as the annuitant) are for the immediate payment of a single payment annuity (lump sum cash) or regular payment annuities which come in a series of regular payments to the issuer.
A good example of life annuities is when a person receives a large settlement from a lawsuit. A company may buy the lump sum and then make payments to the recipient of the settlement for the term of their life.
Most life annuities have an indefinite period as there is no way of knowing how long someone may or may not live.
To annuitize means that the contract owner (annuitant) is ready to begin removing or receiving funds from the annuity. The more premiums that have been paid into the annuity, the longer the payments will continue.
Most people choose to pay into an annuity over time before annuitizing in order to receive lifetime payments.
Some contracts may have stipulations for a beneficiary to receive funds if the contract owner dies before the annuity is empty of funds.
Not every annuitant is the contract owner. A consumer may choose to purchase an annuity and designate a family member, such as a spouse or child, as the annuitant. This person will receive the funds in the annuity for their lifetime or until the annuity runs out of funds.
Different Types of Annuities
There are many different types of life annuities on the market today.
- • The single payment annuity is when the insurer buys a lump sum.
- • A regular payment annuity is when a company buys a settlement in exchange for regular payments, usually a promise from the company or person that must repay a lawsuit (regular payment annuity).
- • Fixed annuities make payments in a set amount or that will increase over time by a certain pre-determined percentage.
- • Guaranteed annuities are also called pure life annuities. These annuities are issued to a recipient that may die before their original payment is recovered, but the payments will continue to a beneficiary.
- • A joint annuity is similar, as the payments are structured so that the payments will continue to the surviving spouse, though payments will stop if the surviving spouse passes away.
- • Impaired life annuities are offered to people that have a severe illness that will cut short their life expectancy. These are only slightly different from other annuity types and a medical underwriter must be involved in creating this annuity.
Who Benefits The Most From Annuities
Life annuities work well for anyone that may have reason to believe that they will need income for retirement beyond savings or to help families during times of economic uncertainty. Someone who has been injured can benefit from annuities. Another situation would be for someone who finds they are suffering from a chronic or terminal illness. An annuity would allow them to leave work and concentrate on treatments, while still paying bills.
Annuities offer excellent interest rates when compared to savings accounts. The cumulative action of interest on an annuity will create a lifetime of income for anyone that is able to invest in an annuity. One of the most well known annuities is a 401K – which is offered by many employers. If considering a 401K, then annuities can fit anyone that is working.
An annuity premium can be best explained as the money paid into the annuity. These premiums are deposits into the annuity itself, much like bank deposits. Each payment made as a premium is a payment into the annuity; these payments will be withdrawn by the annuitant eventually.
Unlike many insurance contracts, all premium payments made into an annuity can be considered payments by the ‘current’ self to the ‘future’ self. For example: today someone purchases an annuity for $20,000; in ten years, the same person can withdrawn money from that same $20,000. Premiums are loans to a future self.
Pros and Cons
There are features of annuities that can be beneficial to the consumer. For instance, a tax-deferred growth on the annuity and, often, a compounding clause. Most annuities have guaranteed rates of return on every dollar invested into the annuity. Choosing to annuitize can also result in lifetime payments.
Different annuity companies have various other benefits that may be beneficial to the collecting party. Each addition to the contract will have specific functions and should be examined carefully.
There are also cons, such as the fact that every guarantee must be funded in some way. When a guarantee is not needed by a consumer, the collector should not purchase them. Cash can be held for some time if the contract purchased has a surrender period. Consumers should avoid a contract with a surrender period unless they have another means of income such as stocks, mutual funds, or savings.
The Internal Revenue Service does restrict how annuities are withdrawn or used.
Removing money from the annuity can result in the cash being taxed or even have penalties attached.