Annuities, What the heck are they?

Annuities, you've heard of them, but what are they and how do they actually work? To some they may sound simple, but there is actually a good bit of difference behind each kind.

What is an annuity?

To understand how they work first you need to understand what an annuity is. In simplest terms, an annuity is designed as a long term investment so that you don't outlive your income. It's a contract between yourself and the insurance company that you choose for your annuity.

Annuities are insurance contracts that guarantee a set amount of money for the rest of a person's life or for a set period of time. An annuity can be acquired with a single payment or a series of payments, and it can start paying off right away or at a later date. Annuities are a popular way to save for retirement.

Annuity distributions are taxed at a higher rate than capital gains from other retirement accounts because they are treated as ordinary income. If you take money out of an annuity before reaching the age of 591 1/2 you'll be charged a hefty 10% early withdrawal penalty.

Now that we've got the basics out of the way, there are three main types of annuities to choose from: fixed annuities, indexed annuity, and variable annuities.

Fixed Annuity: Fixed annuities by design help you reach your goals and they provide a guaranteed return for a set period of time. When deciding on a fixed annuity, you pay a certain amount up front to the insurance company. The insurance company would then guarantee a rate of interest over a specific period of time.

Indexed Annuity: Fixed-indexed annuities are kind of a mix between a standard fixed annuity and a variable annuity. They offer a minimum guarantee of the interest rate plus an interest rate that’s linked to the market index (provided that the market is doing well)

Variable Annuity: A variable annuity is a deferred annuity that allows the annuitant to participate in investment funds, such as bond mutual funds or stocks. It can be very volatile and usually comes with some pretty hefty service fees.

Today, I’d like to take a look at the difference between variable annuities and indexed annuities. Let’s start with the fees associated with each. Understanding what you will be paying towards an annuity is important.

Variable Annuity: Annuity account fee, mortality fee, investment fees, surrender fees, early withdrawal fees and possible additional rider fees (read your contract!) These fees can cost you anywhere from 3 to 4% per year.

Fixed Indexed Annuity: Fixed index fees are much lower, while they could be up to 1.25% of the account's annual value they are optional depending on if you would like to add a rider onto your annuity such as an income rider.

A variable annuity can be extremely volatile. While there is a possibility of higher returns and greater income than fixed Indexed annuities, there is also substantial room for loss. A variable annuity is basically like investing in the stock market, with additional fees associated with it. The only real difference is that the taxes would be deferred in the annuity.

With an Indexed annuity although your balance is related to the stock market, your money isn’t at such a risk. When you first purchase an indexed annuity, the value of the chosen index is taken into account. Upon your contract anniversary date, if the index value is higher then when you first opened the account your annuity will be credited a percentage increase. If the index loses value and goes down, your original interest percentage will remain the same (no loss to you).

As a licensed life, health and annuity agent I hope that you found this information helpful. More articles to come!