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Understanding Annuity and its Types

This article deals with the benefits of investing in an annuity. It also examines the types of annuities that are available to a prudent investor.
An annuity is a financial product that is sold by an insurance company. While a life insurance contract is designed to protect the family members against untimely death of the insured person, an annuity is designed to function as a means of sustenance for a retiree and his spouse, in case they live longer than expected.

Why choose an Annuity?

There are a number of retirement plans, such as 401(k), traditional IRA, Roth IRA, Roth 401(k) and annuity. Each of these have their pros and cons. Income ceiling, mandatory withdrawals, and limits on contribution are some of the factors that have to be taken into account while deciding on a retirement plan.

In case of traditional IRA, 401(k), and Roth 401(k), a person has to start withdrawing his money after the age of 70½ years. This might not be a bad option, apart from the fact that the money, once withdrawn, is taxed. These taxes tend to eat into a retirees nest egg. Roth IRA, on the other hand, has an income ceiling, and there are no mandatory withdrawals. Both traditional and Roth IRAs have limits on contribution.

In case of 401(k), the contributions are tax-exempt and gains are tax-deferred. In case of Roth 401(k), the contributions are taxable while the gains are tax-deferred. Roth IRA contributions are taxable while the traditional IRA contributions may or may not be tax deductible.

An annuity, on the other hand, has no income ceiling, there are no limits on contribution, and withdrawals are not mandatory. Moreover, earnings are allowed to accumulate tax-deferred. Hence, an annuity is desirable for a person who has maxed out his contribution to various retirement plans and is expected to live past the age of 70.

Types of Annuities

Generally, investing in an annuity would involve making a one-time payment to the insurance company. Unlike life insurance, there are no premiums. The insurance company, then invests on behalf of the annuity holder and provides a regular income either on or before retirement.

Fixed and Variable Annuity
A fixed annuity is one that guarantees the rate of return on investment. Depending on the kind of fixed annuity, one might also receive a guarantee for the entire amount invested. A variable annuity, on the other hand, provides a rate of return that depends entirely on one's ability to choose a good portfolio of securities. Unlike a variable annuity, a fixed annuity is not regulated by the SEC, and hence, the strength of the insurance company has to be taken into account before investing in a fixed annuity.

Deferred Annuity
This is the most common type that provides a regular income on retirement. A deferred annuity generally requires regular contributions. The investment grows over time and starts providing a regular income after a period of deferral. Deferred annuities can either be fixed or variable.

Surrender and No-surrender Annuity
Liquidity is the ability to convert assets into cash within a short period of time. On the basis of liquidity, preference annuities can be classified as surrender or no-surrender. Any annuity that is withdrawn before the age of 59 incurs a penalty of 10%. An income tax is also levied on any gains at the time of withdrawal. The only benefit that a no-surrender annuity provides is the ability to withdraw any amount without having to incur any additional penalties. Both surrender and no-surrender annuities allow a person to withdraw up to 15% of the interest earned.

Any investment requires careful analysis. It is more so in case of retirement plans, since our ability to choose a good plan will govern the quality of life after retirement. Every annuity has its benefits and drawbacks, and one must do the required groundwork before embarking on an ambitious retirement plan.