Define Annuity: Explain Annuities and How They Work

Define annuity: we can explain annuities and how they work pretty simply. Generally, they are a series of payments of set size and frequency. The universal common feature of annuities is the option of the holder or holders to receive assured lifelong income in the form of regular payments from the insurance company. The source of these payments is investments made by the holder(s), either in a lump sum or in a series of contributions to the insurance company. The investment proceeds grow tax-deferred prior to disbursal. When the proceeds are distributed to the holder, investment gains are taxed as ordinary income.

An annuity is a contract, usually sold by an insurance company. An annuity contract involves one or more people and an insurance company. They are designed to provide payments to the holder at specified intervals, often after retirement. Frequently, high-interest annuities become the basis for investments of various types. The annuity holder is only taxed at the point at which they start taking distributions or if they withdraw funds from the account. All annuities are tax-deferred, meaning that the earnings from investments in these accounts grow tax-deferred until withdrawal. Annuity earnings are also usually tax-deferred, but as a result they can’t be withdrawn until a certain specified age without penalty.

Fixed annuities guarantee a certain payment amount, while variable annuities do not, but do have the potential for greater returns. Both are relatively safe, low-yielding investments. An annuity has a death benefit equivalent to the higher of the current value of the annuity or the amount the buyer has paid into it. If the owner dies during the accumulation phase, his or her heirs will receive the accumulated amount in the annuity. This money is subject to ordinary income taxes in addition to estate taxes.

To explain annuities, you should understand there are three basic types: Fixed, Variable, and Indexed.

Fixed annuities will often offer an extremely attractive interest rate but guarantee the rate only for the first year of the accumulation period. Since the term of the accumulation period will often exceed the length of the initial rate-guarantee period, these provisions are of special interest to holders.

In a variable annuity, the insurance company doesn’t manage the investment account, the holder does. As such, it’s very important to know what investment options are available and the degree of relative risk they entail.

The variable annuity is considered a security. As such, the Securities and Exchange Commission requires information about it to be disclosed in a document called a prospectus.

Indexed annuity contracts specifies the particular index, such as the Standard & Poor’s 500, used in indexing the investment performance of the accumulation account.

Defining annuity isn’t hard, but explaining annuities can be tricky because of all the variables, terms, and conditions that each type entails.

This entry was posted on Monday, June 29th, 2009 at 6:56 am and is filed under Define Annuity, Explain Annuities. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.