The Basics of Annuities

Dissecting how annuities work, whether you should buy one, and what kind to buy is no easy task. Here's how you can cut through the complexity of annuities to determine whether they are the right long-term product for you.

An annuity is a retirement-planning tool that has two phases: the accumulation phase and the annuitization phase. In the accumulation phase, you give money to an insurance or investment company over a period of time or in a lump sum, and it earns a rate of return. In the annuitization phase, you begin to withdraw regular payments (such as monthly or annually) from your contract until you die.

An annuity has a death benefit, although it is not like one found in a life insurance policy. If you die before you annuitize, your beneficiary will receive either the current value of your annuity or the amount you have paid into it, whichever is greater. For example, if you die when your investments are performing poorly and your account value is less than what you have paid in, your beneficiary would receive the amount you paid in.

Once you begin to receive monthly payments, you no longer have a death benefit on your contract. For example, if you annuitize at age 65 and die at age 67, the insurance company keeps your money in your contract. However, you can buy "term certain" annuities, which guarantee that either you or your beneficiary will receive payments for a certain period of time, such as 10 to 15 years. For example, if you died three years after you began receiving payments from a 10-year term certain annuity, your beneficiary would still receive payments for the next seven years.

The money in your annuity grows tax-deferred, meaning that the money is not taxable until you begin to receive payments from your annuity. Once you receive payments, your gains are taxed at your ordinary income tax rate. If you die before you annuitize, your beneficiary pays taxes on the death benefit. In either case, the person who receives the money (the annuity holder or your beneficiary) is taxed at his or her ordinary income tax rate.

The ideal annuity buyer is 55 or older. Annuities are less attractive to younger investors because there is a 10 percent penalty tax if you withdraw money from your annuity before age 59½ for reasons other than death or disability. However, if you have already retired and need annuity income right away, opt for immediate annuities, which skip the accumulation phase and begin to issue payments as soon as you invest in the contract.

If you have already contributed the maximum amount to your existing tax-deferred retirement plan, such as a 401(k), 403(b), or IRA, you are the ideal annuity buyer. That's because you are already building up tax-deferred money in those plans, and the fees associated with those savings vehicles usually are much lower than those of annuities.