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How Annuities Work

This is how annuities work. In basic terms, if you get payments at regular intervals, that is an annuity. Money is put into an account with an insurance company. In return, the insurance company offers certain benefits. One of these benefits is the potential of recurring monthly or annual payments. However, because annuities are not investments, per se, their rules and how they work are different than other retirement options.

An annuity is more like an agreement than an investment. How annuities work for retirees is due, in large part, to what their contract language is. For example, some types of annuities may provide a fixed interest rate. While others may give owners a potential increase of earnings when the annuity index rises. In both cases, the annuity protects the owner’s initial monies that were put into it.

The Insurance Company's Role In How Annuities Work

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As you may know, market fluctuations do not drop the principal value of a fixed index annuity. Instead, the insurance company is required to keep your initial deposit safe. You provide a certain sum of money. Then, with the terms of your annuity, the insurance company agrees to issue you a certain amount. This amount might be in the form of regular payments monthly, or could be taken just once per year. As the law requires, insurance companies set aside a reserve amount in order to provide protection for your assets. Because of this, a fixed index annuity (FIA) may be able to offer protection from market crashes or downturns.

There are 2 primary stages of an annuity agreement. First, is a phase called "accumulation." Next, is the "distribution" phase. The first part of the agreement does the work of letting your money grow. In fact, it starts as soon as you purchase your annuity. Once you hit the distribution stage, however, you are able to begin taking money out. If you choose to do this, how much you can take out and when it can be taken with vary depending on your contract terms.

To clarify, an annuity may have different rules on if/when potential growth may occur. FIAs, for example, usually have some growth potential, but may also have a set interest rate. An FIA does not drop in original value even if the market crashes. Alternatively, variable index annuities have more risk, because they link directly to the changes in the stock market. In either case, the money in the annuity has a period of waiting. The money stays put for while until the terms of the annuity indicate you can begin to take some out.

After the potential growth stage, distribution is next. At this point, you may decide to begin taking an income from your FIA. Indeed, this is one of the benefits some retirees enjoy with an annuity. Without a penalty, you may be able to take specific annual or monthly payments. Of course, you must pay applicable taxes. However, tax implications will vary from person to person. Be sure to consult with a tax advisor for specific tax questions. Regardless, this phase may be able to offer you an income for life in retirement.

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What about taxes?

Taxes also play a role in how annuities work. During the first stage, the growth in your FIA account does not incur immediate taxes. Instead, you pay them when you take money out. Unlike a CD (certificate of deposit) or a traditional savings account, an FIA does not require taxes until the money is taken out. For those looking for alternatives in tax planning, this may be useful information.

There are other possibilities for benefits, too. For example, if you happen to be younger than 59 1/2 and get an early retirement package. In this case, let’s say you got a lump sum for the employer’s 401(k) profit-sharing plan. Usually, this would generate a large tax bill. But, if this money could roll into an annuity instead, it may be possible to put off those taxes. You should always discuss with a professional before moving forward.

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