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What is an Annuity?

An annuity is an insurance product that pays out a fixed sum of money in specified increments for a predetermined period of time, beginning either immediately or at some point in the future, often with the purpose of providing a steady stream of income during retirement.

There are several types of annuities that offer varying payment streams, including fixed, variable and equity-indexed annuities. Fixed annuities pay a guaranteed principal payment, whereas the principal payment for variable annuities fluctuates based on the investments held. Equity-indexed annuities pay a guaranteed principal and also allow policyholders to participate in market upside.

The payout for an annuity can be either immediate or deferred:

  • Immediate annuities start payments after a lump sum payment is made, such as a retirement fund that is rolled over into an annuity.
  • Deferred annuities will begin to payout at a future date and can be set up with a lump sum premium, several premiums or recurring contributions.

Annuities also differ in how payments are distributed. Some will continue payments until the death of the beneficiary or the beneficiary and spouse. Others will continue to pay out for a guaranteed number of years even if the beneficiary dies before that. Others still will combine the guaranteed number of years with joint life expectancy.

Annuities can be set up within a retirement account, where your contributions are tax-deductible, but subject to contribution limits. If you own an annuity outside of a retirement account, you will be contributing after-tax dollars and there are no contributions limits.

Some disadvantages to annuities are that earnings are taxed as ordinary income, not as capital gains. Additionally, annuities are not backed by the FDIC, so the strength of the issuing insurance company is extremely important.

Jemma Everyday Wisdom: For retirees, the prospect of an income stream for the rest of your life can be very attractive, but annuities are a complex product with many rules and nuances. To be used appropriately, approach annuities in a highly-individualized way, and consult your Jemma financial advisor.

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