What is an Annuity?

In the most basic terms, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually the term “annuity” relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company.

There are many categories of annuities. They can be classified by:
 Type of investment – fixed or variable
 Purpose – accumulation or pay-out (deferred or immediate)
 Pay-out commitment – fixed period, fixed amount, or lifetime
 Tax status – qualified or nonqualified
 Premium payment arrangement – single premium or flexible premium
An annuity can be classified in several of these categories at once. For example, you might buy a nonqualified single premium deferred variable annuity.

Annuity Advantages
 Tax deferral on investment earnings
Many investments are taxed year by year, but the investment earnings—capital gains and investment income—in annuities aren’t taxable until you withdraw money.
 Some protection from creditors
 An array of investment options, including “floors”
Many annuity companies offer a variety of investment options. You can invest in a fixed annuity which would credit a specified interest rate, similar to a bank Certificate of Deposit (CD). If you buy a variable annuity, your money can be invested in stock or bond (or other) mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point.
 Tax-free transfers among investment options
In contrast to mutual funds and other investments made with “after-tax money,” with annuities there are no tax consequences if you change how your funds are invested.
 Lifetime income
A lifetime immediate annuity converts an investment into a stream of payments that last as long as you do.
Annuity Disadvantages
 Cost
Annuities can be expensive products.  I have seen annuities that have 3.00% total expense ratios which include administration, contract fees, and underlying investment option management fees.

 Complexity
Most annuities are relatively complicated and most are sold to older Americans.  This can be a bad mix.  You want to make sure you understand the annuity before making a commitment.  When I have been asked about annuities by a person considering the product or someone who owns an annuity, they usually start the sentence by saying,”I don’t know much about these things.”  This is always a concern.

 Surrender charges
Many annuities have surrender charges and they can start at over 10%.  Most people have trouble connecting the dots that if you invest $50,000 and withdrawal the money, you will be charged $5,000.  Make sure you understand the charge, the time frame, and any exclusions.

Like any investment product, annuities can be a good investment for the right situation.