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Components of an Annuity
An annuity is a function of time, money, and – to varying extents – market forces. It is a contract between the issuing party (insurance company or broker) and the purchaser (annuitant), the aim being to grow the investment (annuity) and to create a retirement income for the purchaser (annuitant). The main components of an annuity are the following.
This is the amount of money the annuitant pays for the annuity to begin. It can either be an outright purchase (lump sum or single premium) or in the form of regular deposits over an agreed period time.
The money the annuitant deposits into the annuity goes into an account. Depending on the type of annuity, the account funds can be invested separately or along with the insurance company's selected portfolios. When invested separately, the annuity earnings vary depending on the performance of the annuitant's chosen stocks or bonds. This is called a variable annuity.
When invested along with the company's portfolios, the company guarantees a fixed rate over a fixed period. This is called a fixed annuity. The guarantee, of course, rests on the company's ability to pay claims–hence the necessity of choosing a strong, stable insurance company to hold the annuity.
This is the set period of time during which the insurance company holds the annuity. It comprises an investing phase (when assets begin to build for potential growth) and an income phase (when the company pays out an income to the annuitant).
If the annuitant does not opt to withdraw the annuity as a lump sum upon maturity, the annuitant may opt for a monthly, quarterly, semiannual, or annual distribution of annuity income. Distribution payment options are generally designed to produce a steady stream of retirement income that the annuitant cannot outlive.
When an annuity reaches maturity, the annuitant is given the option to either withdraw the entire investment including earnings (lump sum withdrawal) or to receive distribution over a period of time (usually for life). If the annuitant withdraws an annuity prior to maturity, the annuitant incurs penalties.
US federal income tax laws charge the annuitant a 10% penalty (plus other income taxes) if the annuitant withdraws the annuity before age 59½. The insurance company also penalizes the annuitant for early withdrawal by deducting surrender charges or withholding interest credits if the annuity is not held to maturity.
The annuitant makes contributions or payments into the annuity to build retirement assets. Contributions can be made through payroll deductions, checks, or regular deposits.
Payroll deductions are generally done pretax, making this investment vehicle a good way to reduce tax liability–aside from taxes already deferred since the annuity's earnings are allowed to multiply tax-free. In such cases, taxes are only paid when the annuity is withdrawn.
Aside from their purpose as a retirement safety net, annuities are popular because of the tax savings or deferments they are able to provide.
Consumers should discuss issues with and rely on the advice of their own tax, legal, financial, investment and/or other professional advisors.
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