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Annuities and life annuities are plans through which an individual pays a lump sum of money to be invested by the annuity company and payments are sent back to the annuity holder over a set period of time. Life annuities are typically purchased by retirees to maximize yearly income and gain returns on investments without having to manage those investments.
How Life Annuities Work
Annuities can be thought of as loan reversals where the individual pays a large sum of money to a company and the company pays back that loan with interest over a period of time.
Life annuities are defined as plans in which an individual pays a set sum and then receives annual payments over a decided period of time during the individual’s life. Annuities are designed to provide a pre-determined yearly income to the life annuity holder once the annuity has been established. Individuals can either pay into the annuity fund during their working years or pay a large sum from a previously established account once they are close to retirement.
Once purchased, the cost of a life annuity plan is used to purchase stocks, bonds and other investments that typically provide high returns over long periods of time. This accumulated interest is used to help support the life annuity payments. Life annuity interest (interest accumulated on the amount invested in the life annuity) is tax-exempt until payments on the annuity are paid back to the investor. Once the withdraw period begins, the investments are taxed.
Most companies selling life annuities have life annuity plans that have set payments that end as soon as the annuity holder dies. No payments are made to survivors or beneficiaries and any remaining investment is retained by the company. Life annuity payments are usually calculated based on the average lifetime of an individual. If an individual lives beyond this calculated time, then the individual may end up being paid more money than he or she paid into the system. There are, however riders that can be attached to Life annuity plans.
Although typical life annuities will pay the annuity holder until time of death, there are also riders that can be added onto the contract to assure of others receiving the annuities. Some of these options include:
- Life with Period certain – payment is received by the individual until death, but with a provision that states that if the individual dies within a certain period of time, the beneficiaries will then receive payments through a predetermined period.
- Installment – Refund – guarantees that after death, whatever is left in the annuity fund will be paid to the beneficiaries.
- Joint and survivor – in cases of spouses, the annuity pays out beyond the death of the spouse who owns the annuity. The annuity will pay the surviving spouse until death.
Life annuity plans can be tailored to each individual. Initial payments and total costs of annuities vary as well as the amounts paid out over time. The annual payments back to the annuity holder can vary in both amount of money as well as the frequency (the number of payments in a given period of time). Individuals can decide on how much is paid to them each time or how frequently payments are made, typically they cannot choose both. Once payment options are chosen, however, they cannot be changed. Size of payments depend on:
- Total amount of money in the annuity contract
- Whether there are minimum required payments
- Life expectancy of the individual
Payment into an annuity can happen over period of time or the life annuity can be purchased in on lump sum. Some payment options into a life annuity are:
- Single-Premium Annuities – purchase of annuity with one lump sum
- Flexible-Premium annuities – purchase of an annuity is made through a series of payments.
Payments from an annuity can also take on variables. Some annuities can defer payment until a later date while others begin payment out immediately. Some payments to the annuity holder can include:
- Immediate Annuity – begins payment to the annuity holder immediately after purchase of annuity contract.
- Deferred Annuity – payments to the annuity holder begin many years after the contract begins. This can be good for individuals who wish to extend their income far beyond retirement.
- Fixed Annuities – The annuity company puts funds into investment and guarantees a certain interest rate over a certain period of time (from months to years)
- Variable Annuity – there is no fixed interest rate and more risk in investment with the annuity fund.
Frequency of payments and amount of money in each payment during the payout period can also vary in life annuities. Some options are:
- Fixed Amount – gives the annuity holder a fixed amount of income each month chosen by the individual. This payment is constant until the annuity runs out.
- Fixed Period – gives the annuity holder a fixed income over a period of time chosen by the individual. The longer the period, the less payout per period of time.
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