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1. What is an annuity?

An annuity is a contract between you and an insurance company to cover specific goals, such as retirement, lifetime income or long-term care costs.

2. Why buy an annuity?

You buy an annuity because it does what no other investment can do: "provide guaranteed income for the rest of your life no matter how long you live.

This makes annuities popular retirement planning strategies. Annuities can provide more tax-sheltered ways to save for retirement if you have already maxed out your 401(k) and IRA. Since annuities have no contribution limits, you can save to your heart’s content.

And since your annuity will provide guaranteed income later, you may be able to take a more aggressive investing strategy with your other assets.

3. How does an annuity work?

An annuity works by transferring risk from the owner, called the annuitant, to the insurance company. Like other types of insurance, you pay the annuity company premiums to bear this risk. Premiums can be a single lump sum or a series of payments, depending on the type of annuity. The premium-paying period is known as the accumulation phase.

Unlike other types of insurance, you don't pay annuity premiums indefinitely. Eventually, you stop paying the annuity and the annuity starts paying you. When this happens, your contract is said to enter the payout phase.

There's great flexibility in how annuity payments are handled. Annuities can be structured to trigger payments for a fixed number of years to you or your heirs, for your lifetime, until you and your spouse have passed away, or a combination of both lifetime income with a guaranteed "period certain" payout. A "life with period certain annuity" pays you income for life, but if you die during a specified time frame (the period certain years), the annuity will pay your beneficiary the remainder of your payments for the contractual period you chose at the time of application.

As with Social Security, annuity lifetime income streams are based on the recipient's life expectancy, with smaller payments received over longer periods. So, the younger you are when you start receiving income, the longer your life expectancy is, or the longer the period certain term is, the smaller your payments will be.

4. The different types of annuities.

There are two main types of annuities: deferred and immediate. Deferred annuities provide a stream of income later, while immediate annuities provide income now. Within the deferred and immediate categories are fixed and variable annuities.

An immediate annuity begins paying income (almost) immediately. Although it is annuitized immediately, an immediate annuity does not start paying income right away. You make a single lump sum payment to the insurance company, and it begins paying you income one annuity period after purchase, which can be 30 days to one year later.

The period is based on how often you elect to receive income payments. For instance, if you choose monthly payments, your first immediate annuity payment will come one month after you buy it. Because payments begin so soon, immediate annuities are popular among retirees.

Deferred annuities provide tax-advantaged saving and lifetime income. With a deferred annuity, you begin receiving payments years or decades in the future. In the meantime, your premiums grow tax-deferred inside the annuity. They are often used to supplement individual retirement accounts and employer-sponsored retirement plan contributions because most annuities have no IRS contribution limits.

5. A fixed annuity for principal protection.

Fixed annuities pay a guaranteed minimum rate of return and provide a fixed series of payments under conditions determined when you buy the annuity.

During the accumulation phase, the insurance company invests the premiums in high-quality, fixed-income investments like bonds. Because your rate of return is guaranteed, the insurance company bears all the investment risk with fixed annuities.

It works much like a certificate of deposit by guaranteeing a rate over a fixed period. However, unlike CD interest, the interest is not taxed annually but rather allowed to grow tax-deferred until withdrawal.

6. Annuities may have early withdrawal penalties.

Also, like CDs, MYGAs and other deferred annuities have surrender charges if you withdraw your money early. Surrender periods vary from two years to 10 or more, and the corresponding charges typically decline with time. For example, a deferred annuity with a 10-year surrender period would charge 10 percent on money withdrawn the first year, 9 percent the second year, 8 percent the third year and so on.

However, "nearly all companies give you access to at least the interest, with many allowing you access after 12 months to either 10 percent of your original premium deposited or 10 percent of your account value," Bender says.

Bear in mind that as with IRAs and 401(k)s, earnings withdrawn before age 59½ may be subject to a 10 percent federal tax penalty. Likewise, annuity income is taxed as ordinary income the year it is received.

Always consult with your tax professional before making decisions on the tax ramifications of annuities or any retirement vehicle.

8. How annuities are taxed.

Annuities are tax-deferred, which means you do not pay taxes on the money while it is in the annuity. Like a 401(k) or IRA, you only pay taxes on the money when you withdraw it.

If you fund your annuity with pretax dollars, called a “qualified annuity,” then everything you withdraw will be taxed at your ordinary income rates. If, however, you used after-tax dollars to fund your annuity, called a “nonqualified annuity,” you will not be taxed on the portion of your withdrawal that represents a return of your original principal. Only your earnings will be taxed in a nonqualified annuity.

Nonqualified annuities use something called the exclusion ratio to determine how much of your withdrawal is principal and how much is earnings. The exclusion ratio is designed to spread the return of your principal out over your actuarial lifetime.

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