If you have thought about planning for retirement, you may be somewhat familiar with the term “annuity.” Practically speaking, an annuity is like a life insurance policy in reverse. A life insurance policy pays the insured upon death. An annuity pays while the person is still living. Understanding the purpose of an annuity can help you decide whether establishing an annuity is the right thing for you.
Definition of an annuity
The technical definition of an annuity is a promise to make a series of payments, of a specific value, for a certain period of time or until a specific event occurs. In terms of investment, an annuity is commonly used for retirement planning.
Purpose of Annuities
Originally, life insurance companies created annuities as a way to avoid the risk of policyholders outliving their income source. Now, annuities have become very powerful investment and retirement tools. Annuity products can be used to assist individuals in paying for disability and long-term care. They are also frequently used as tax shelters for wealthy individuals when their income is too high to make use of an Individual Retirement Account (IRA).
Common types of annuities
There are essentially two types of annuities, each with its own purpose and advantages: tax-deferred annuities and income annuities. A tax-deferred annuity allows you to accumulate savings during your lifetime, while an income annuity provides a steady source of income for your retirement years.
If you have made the maximum contributions to your 401k or IRA, but you need to increase your retirement savings, a tax-deferred annuity can be a very valuable retirement planning tool for you. Tax-deferred annuities have not contribution limits, and can offer both variable and fixed investment options. Another benefit is that you are not required to pay tax on income earned within the annuity, which can be converted into an income annuity upon your retirement.
Deferred variable annuity vs. deferred fixed annuity
If you choose a deferred variable annuity, your funds will be based on the performance of the stocks or bonds. This means you are exposed to a certain degree of risk. However, the advantage of a variable annuity is that it offers the potential for increased long-term returns.
On the other hand, a fixed annuity is more like a certificate of deposit (CD). It provides guaranteed rates of return for a specific number of years. If you consider yourself a conservative investor, the benefits of a fixed annuity may suit you better. The only real downside is that fixed annuities, unlike CDs, are not insured by the FDIC.
An income annuity is a different animal. The purpose of this type of annuity is to guarantee income for you during retirement. The income can be guaranteed for a specific period of time or it can continue until your death, which means you will not outlive your income. The amount of income is based on your age when the annuity is purchased and the state of the economy.
If you have questions regarding annuities, or any other retirement planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.