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What is an annuity, with a simple example?
An annuity is a contract with an insurance company. You hand over a sum of money, and the insurer promises either to grow it on stated terms for a set number of years or to pay you income, often for life. That promise depends on the claims paying ability of the issuing insurer. The price is access, because early withdrawals usually cost a surrender charge.
An annuity is a contract, not an account, and that one word explains most of it.
A bank account holds your money. A brokerage account holds investments you own. An annuity is neither. It is a contract between you and an insurance company, and what you own is the insurer's promise.
That promise comes in two basic forms. Either the insurer agrees to grow your money on stated terms for a set number of years, or it agrees to pay you a stream of income, sometimes for a fixed period and sometimes for as long as you live. Plenty of contracts do the first and then offer the second.
Because it is a promise and not a holding, it is only as strong as the company making it. Any guarantee inside an annuity depends on the claims paying ability of the issuing insurer. That is why the company's financial strength matters more here than anything in the brochure.
Here is one, followed from the day it is signed.
Take a 64 year old who puts 150,000 dollars into a five year fixed annuity. The figures are illustrative. Real rates move with the market on the day you buy.
Say the contract declares 5 percent a year for the five years. The interest is added inside the contract, and nothing is taxed while it stays there. At the end of year five the value is about 191,000 dollars.
When the money comes out, the roughly 41,000 of growth is taxed as ordinary income, not as a capital gain. If the 150,000 was money you had already paid tax on, it comes back without more tax. If it came from an IRA, all of it is taxable, the same as any IRA withdrawal.
During those five years the money is not fully available. Many contracts let you take about 10 percent a year without a penalty. Take more and a surrender charge applies, often several percent in the first year and stepping down to zero by the end of the term.
At year five there are three doors, and only one of them is permanent.
When the term ends, the owner can take the money and leave, move it into another contract, or turn it into income. The first two keep the money yours. The third changes what you own.
Turning it into income is called annuitizing. The insurer takes the 191,000 and pays a set amount every month for life in return. After that there is no balance to withdraw. You own a paycheck, not a pile. Our page on what 100,000 dollars pays a month works through how big that paycheck tends to be, and why most of it is your own money coming back.
That step usually cannot be undone. It is the one decision in the whole example that deserves the most time, and it is the one most often rushed.
Lifetime income works because not everyone lives to collect it.
Picture a thousand people, all 69, who each turn the same amount into lifetime income. Some will die in their seventies, and their payments stop. The money that would have gone to them keeps paying the ones who reach 95. Nobody knows in advance which group they will be in.
So the insurer can pay each of them more per year than any one of them could spend alone without worrying about running out. The extra comes from the pool itself. Almost nobody explains this part, and it is the whole reason annuities exist.
Here is the trade. You give up the chance to leave that money to anyone, and in return you get paid for the risk of living a long time. If you die early, you lose the trade, and if you live long, you win it. That is insurance, which is why insurance companies sell it.
If you do not need either promise, you do not need an annuity.
Strip away the features and every annuity sells one of two things: a set rate for a set term, or income that keeps coming after savings would have run out. If neither is a problem you have, there are cheaper tools, and our page on what is better than an annuity names them.
We should say where we stand. opfinances.com is a licensed insurance agency. We are not a financial advisor and not a fiduciary, and we are paid a commission by the insurance company when a contract is placed. That is exactly why this page leads with the example and not the pitch. You should understand the contract before anyone quotes you a rate on it.
Before you decide
Questions worth asking.
Is this contract built to grow money for a set term, to pay income, or both, and which part am I actually buying?
What is the surrender charge in each year, and how much can I take out each year without paying it?
If I turn this into income, can I ever change my mind, and what happens to what is left when I die?
Which insurance company is making the promise, and how is its financial strength rated?
How will the growth be taxed when it comes out, and does it change anything that this money came from an IRA?
How are you paid on this contract, and are you paid more if the surrender period is longer?
Related
Is an annuity an investment?
Not in the way a fund or a stock is. You do not own the underlying assets. You own a contract with an insurer, and what you earn is whatever the contract promises or credits, backed by the claims paying ability of the issuing insurer. Some annuities are tied to markets, but you still own the contract, not the market.
How does the insurance company make money on an annuity?
It invests the premiums, mostly in bonds, and keeps the spread between what it earns and what it credits or pays you, plus any fees and rider charges. On lifetime income it also relies on pooling. Payments that stop when some owners die help fund the owners who live the longest.
Can I get my money back out of an annuity?
Usually, with limits. Many contracts allow around 10 percent a year without a penalty, and larger withdrawals during the surrender period cost a charge that steps down over time. Once a contract has been annuitized into lifetime income, there is normally no balance left to withdraw.
What are the main types of annuities?
Fixed annuities credit a declared rate. Fixed indexed annuities credit interest based partly on a market index, within caps and limits. Variable annuities rise and fall with investments you pick inside the contract. Immediate income annuities skip the growth years and start paying right away. The example on this page is the first kind.
Who should not buy an annuity?
Anyone who may need the money back during the surrender period, anyone with no income gap to fill, and anyone who has not yet looked at delaying Social Security, which is the cheapest lifetime income most people can get. An annuity solves a specific problem. Without that problem it is an expensive place to keep money.
Where this fits.
This question sits inside a bigger one. Annuities walks through the whole decision rather than this one piece of it.
On Point Finances is a licensed insurance agency, not a tax, legal, or investment adviser. This page is general education, not a recommendation, and reading it does not create a client relationship.