How Does an Annuity Work

An annuity is a good retirement-saving plan sold by financial institutes or insurance companies. In this plan, the buyer or the annuitant pays investment amount to the insurance company, which is then provided as regular payments to him/her.
An annuity is considered to be a perfect insurance product for maintaining a good lifestyle after the retirement. In comparison to other retirement saving plans, these offer greater benefits in terms of flexible premium-payment option, no contribution limit, higher interest returns, tax advantages, and a fixed periodic income. These are also a good saving option for a child's education.

Working

In general terms, an annuity is a financial contract signed between a financial institution and an annuitant. Usually, the financial institution that sells the annuity product is an insurance company, which is also referred to as the issuer. The annuitant or the person who buys the product is called a buyer. In this contract, the buyer pays a lump sum amount or periodic payments to the insurance company, under the condition that the company will provide regular payments to him immediately or after a specific period.

The term of this plan can be divided into two phases: the accumulation phase and distribution phase. In the accumulation phase, the buyer deposits money either in lump sum or regular payment to the insurance company. In case of distribution phase, the insurance company pays periodic payments similar to income payments to the buyer. An annuity plan is often associated with a life insurance component, in which a lump sum or periodic payments are made to the beneficiary, in case the buyer dies before getting these payments.

The periodic payment by the insurance company to the buyer is allowed when he completes a specific age. In most cases, the age of the buyer should be at least 59½ years; then only withdrawal of periodic money can be done. If withdrawals are made prior to this specific age, certain charges may be applied; for example, tax penalties and surrender charges.

As far as charges application is concerned, the income tax applied is 10 percent of the deposited or investment money, plus regular tax payment rate on the interest returns. The surrender charges are calculated by the insurance company, depending upon the withdrawal time and the plan. In order to avoid all such circumstances, a buyer should analyze his requirements and the terms and conditions of the plan before buying.

Types

There are two major types of annuity, namely fixed and variable. In the former case, the insurance company assures a fixed interest rate during the period in which the buyer is accumulating the money. The issuer also guarantees a series of fixed payments for a specific duration (for example, 20 years) or as long as the buyer's lifetime (or his spouse lifetime).

In a variable annuity, the money being accumulated by the buyer is invested in various plans. He has the right to choose investment options, mostly mutual funds. The interest returns and the amount to periodic payments solely depend on the return on investment (ROI) or performance of the mutual funds that he has selected. Though the variable type involves a higher risk, it can also provide high interest rates and periodic payments than a fixed plan.

In addition, annuities can be divided into immediate and deferred types, based on the payout option. An immediate one, as the name suggests, provides payments to the buyer immediately, whereas periodic payments are started on a future date in the case of deferred type. Annuity is called a single premium type, if the payment by the buyer is in lump sum, whereas it is called regular payment annuity, if premium payment is made regularly.
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