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An annuity is an insurance contract in which you make a lump sum investment or series of payments and, in return, receive a stream of income for a specific period or for life. Annuities come in a number of variations, and, as with any investment, the more you understand how the tool you are using fits your needs, the better. The two main types are fixed and variable.
With a fixed annuity, an insurance company guarantees a rate of return on your investment, but the rate is relatively low, and payments do not adjust with inflation. Interest is tax-deferred, so you only pay tax when you receive annuity payments. The interest rate is usually guaranteed for a specific period of time, such as 3 or 5 years.
Fixed annuities may be a good choice for people with low tolerance for risk or who prefer to protect their investment from loss, even if it means they give up the possibility for larger investment gains. The stable monthly income of an annuity may be desirable for people who need to supplement Social Security or who want to be sure they don’t outlive their funds.
A variable annuity allows you to choose how your funds are invested, and the returns will vary depending on the performance of the investments you choose. Because they are based on riskier investments, variable annuities guarantee a minimum payment amount, but the actual payout may increase or decrease based on the performance of the investments.
Higher potential returns are a major advantage of variable annuities, but your investment may lose value if the securities in your annuity portfolio decline in value. The structure and tax implications of variable annuities can also be quite complex, so it’s important to understand whether and how well they fit your needs as an investor.
Immediate vs. deferred. Immediate annuities begin making payouts as soon as the initial investment is made, while deferred annuities begin at a future time, such as age 75, 80, or older.
Annuitizing. When you start receiving regular payouts, the legal status of your account changes—it has “annuitized”—and you can no longer change the terms of the annuity or cancel it.
Death benefits. What happens to invested funds if you die is a big variable among different annuity contracts. There could be payments to a beneficiary or tax liabilities for your estate.