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How Annuities Work?
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How Annuities Work: Let Us Explain The Basics
How do annuities work? Well, if you are receiving payments at regular intervals, that is an annuity. Your funds are put into an account with an insurance company. In return, the insurance company offers certain benefits.
One of the advantages is the possibility of recurring monthly or annual payments. But, because annuities are not investments, per se, their rules and how annuities work differently than other retirement plan options.
An annuity is more like an agreement, rather than an investment. How annuities work for retirees is due, largely, to what their contract language states. For example, certain annuities could provide you with fixed interest rates. However, other types of annuities can provide owners a potential increase in earnings when the annuity rises. But in both cases, the annuity protects your initial funds that were put into the contract.
What Is A Fixed Index Annuity Investment?
A fixed index annuity has the benefit of shielding your money because it does not fluctuate with the stock market. In contrast, a fixed index annuity (FIA) is an agreement or contract between the insurance company and yourself. You contribute a lump sum of capital and at the same, the insurance company agrees to pay you an interest rate based on how the index performs. Also, there is a fixed term and a pre-set schedule of payments.
Even though your fixed index annuity (FIA) is tied to the stock market, your funds are not directly invested into the stock market. So, if the stock market rises you can profit from a reasonable rate of return.* But, if the stock is down while you may not gain interest, at least your money is protected. During that time period, you aren’t gaining any money, your saving money. The law dictates, that the insurance company sets aside a “reserve” as assurance for your funds. Basically, your contract and the strength of the insurance company.
The Phases Of An Annuity
Annuities have two central phases – the first being the accumulation phase and the second being the distribution phase. During the first phase, the accumulation phase it is important to understand how annuities work. This phase begins when you purchase the annuity and sign your contract with the life insurance company.
Next, during the distribution phase, you can withdraw your income. However, as will all annuities, each one has different terms. This includes how much money you can remove and when you can start receiving payments. Other details of your annuity contract may fluctuate as well.
Annuities will grow based on the type of annuity it is. For example, variable annuities can actually lose value if the market is declining. While fixed annuities can earn at a particular rate.
Ultimately, index annuities could give you the best of both worlds. You get an opportunity to produce a reasonable rate of return all while your principle stays protected. Regardless of the type of annuity, annuity’s require a period of time for your funds to grow.
The next stage is distribution. At this time in your annuity contract, you can withdraw your money. Your income payments can now come from your annuity. This is a big benefit to annuity in the first place.
Over time you can create scheduled annual payments. Most importantly you can create a lifetime term. You can also take monthly or annual income payments. This means that you take income instead of annual payouts and payments.
Many annuities can offer you versatility. You can pick from various types of payout alternatives, based upon your needs and goals. One of these choices includes a guaranteed lifetime income or you could let your annuity increase without withdrawing capital.
Taxes and Annuities Explained
During the first stage of your annuity – the accumulation stage, your money grows tax-deferred. That means while your money grows it’s not taxable. In fact, you won’t pay taxes until the money is withdrawn. If you are looking to reduce your current tax situation, an annuity might be a good option.
Other tax benefits may be achievable as well. For example, people who have not reached 59 ½ who have received a lump sum from a previous employer’s 401(k). In this circumstance, if your lump sum is part of a severance or early retirement, you’d need to pay substantial taxes or a surrender charge. However, if you convert that money into an annuity, you might be able to delay those taxes for a while.
Before making any decisions you should always consult with a tax advisor beforehand.
*Reasonable rate of return over time.