What Is An Annuity?

After reading a recent post Sean asked, what an annuity was. Well Sean let me try to explain it to you.

In its most general sense, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually the term “annuity” relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company.

Bankrate.com probably has the best description when it describes them this way,

An annuity is a life insurance contract sold by insurance companies, brokers and other financial institutions. It is usually sold as a retirement investment and is paid for before retirement in exchange for lifetime payments after retirement. Before talking about pros and cons, let's look at what they're selling.

There are two types of annuities, fixed and variable. Fixed annuities carries an interest rate that starts out as a fixed percentage and is usually adjusted annually. On the other hand a variable annuity is a bit more complex. With a variable annuity the purchaser selects from a list of mutual funds and his payments are invested in the funds he picks; future payouts depend on the funds' performance over the years.

What's good about an annuity?
Assuming you're buying it with after-tax dollars, here are some of the pros of investing in an annuity:

Lifetime income is guaranteed

Earnings are tax-deferred

There is no limit on how much you can contribute

There are no income restrictions

You can switch investments within your contract without paying taxes

You get a premium for outliving your life expectancy

What's bad about an annuity?

Fee and commissions can be high and cut deeply into your return. Look for low-load or no-load contracts with low fees.

Annuities are generally bought with after-tax dollars.

At payback time, income is taxed as ordinary income, even if most of it is from capital gains. Not good if you're in a 28 percent or 39.6 percent income-tax bracket and your capital gains tax rate is 20 percent.

Annuity talk can sound like doublespeak, making it hard to separate the good contracts from the bad ones.

An annuity is a long-term investment, and bailing out early can kick up penalties, taxes and surrender charges.

You could be paying for life insurance you don't need.

You need a long stretch of time and a big chunk of money to make it work.

In addition, the interest may be no better (or barely) then a common savings account.