The simple guide to how annuities work

When it comes to planning for retirement, a wide variety of annuity options exist that could help provide steady income. However, to truly make the most of these financial products, it’s important to understand how annuities work. Annuities come in different types, each with unique features, and knowing how they function may help individuals choose the right one to fit their retirement goals. Whether it’s understanding the annuity rate of return, payout structures, or the role of timing, exploring annuity basics is crucial for anyone considering this financial tool as part of their long-term strategy.

Annuity basics explained

An annuity is designed to provide a steady stream of income, typically during retirement. Annuities are purchased through an initial lump sum or a series of payments, and in return, the account might pay out regularly for a specified period or for the lifetime of the individual. One of the main benefits of an annuity is the potential for guaranteed income which could offer financial protection throughout retirement.

Annuities are commonly targeted to individuals between the ages of 50-70, and can also be a beneficial option for younger adults who are starting to build their retirement income plans. Understanding the different types, common misconceptions, and how annuities work may help you make more informed decisions about how they can factor into your retirement plan.

How annuities work

An annuity is a contract with a life insurance company where premiums are paid in exchange for regular payments or a lump sum in retirement. The balance typically grows tax-deferred and may provide a guaranteed income stream. Annuities are commonly used in retirement planning to enhance financial stability and help ensure a steady stream of supplemental income. A major concern of retirees is outliving their savings. How long do annuities last? The duration of an annuity depends on the type that is purchased. Fixed annuities typically have a set payout period, often lasting up to 30 years, while lifetime annuities provide payments for the rest of an individual’s life. Whether choosing a fixed or lifetime product, annuities can be ideal for income planning and offer the ability to plan for long-term financial protection throughout retirement.

How to buy an annuity

When thinking about purchasing an annuity, working with a financial professional could help determine if an annuity is a good fit, explore which type of annuity might align with your retirement goals and personal risk tolerance, and select a trusted life insurance partner. They can also help you understand the terms of the annuity, such as the payout options, fees, surrender charges, and any market value adjustments, helping to avoid surprises down the road.

What to know about an annuity rate of return

An annuity rate of return refers to the rate at which an annuity’s value grows over time, potentially affecting the amount of future income it provides. Several factors influence the rate of return, including the type of annuity, interest rates, and fees. For example, fixed annuities typically offer a guaranteed return based on a set interest rate, while variable annuities could fluctuate depending on the performance of underlying investments.

For individuals purchasing an annuity for retirement, it’s important to understand how the annuity rate of return will impact future income and overall retirement planning. A lower return might be acceptable if the goal is guaranteed income with minimal risk, but higher returns may be more desirable for those willing to accept more variability in exchange for greater growth potential.

How do annuities work in retirement?

Most annuities have specific requirements regarding when funds can be accessed, typically based on age or the terms of the contract. Once you meet these conditions, you can choose how to receive payment from your annuity. Some individuals opt to take a lump sum, which includes the original investment plus any interest earned, while others may prefer monthly payments for a consistent income stream throughout retirement. This flexibility allows annuities to cater to different income needs in retirement, providing a reliable source of funds for those who choose regular payouts.

When annuity payouts begin, the taxes to be paid depend on the type of annuity and how it was funded. For a non-qualified annuity (funded with after-tax dollars), only the earnings portion of each payment is taxable, while the principal is tax-free. For qualified annuities (funded with pre-tax dollars, like those in retirement accounts), both the principal and the earnings are taxable as ordinary income. It's important to consult with a tax professional to understand the full tax implications of annuity payouts based on individual circumstances.

Adding an annuity to a retirement plan

Supplementing a retirement plan with an annuity can provide valuable financial protection by offering a predictable income stream and helping ensure that individuals won’t outlive their savings. Whether choosing a fixed or variable annuity, this financial solution could complement other retirement savings strategies by offering stability and peace of mind in retirement. As with any financial product, it's essential to evaluate personal goals, risk tolerance, and work with a financial professional to determine how an annuity might fit into an overall retirement strategy. By taking a thoughtful and informed approach to integrating an annuity into a retirement plan and understanding how an annuity works may help pave the way for a more comfortable financial future.

The term financial professional is not intended to imply engagement in an advisory business in which compensation is not related to sales. Financial professionals that are insurance licensed will be paid a commission on the sale of an insurance product.

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