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What are the Basics of Annuities?

Annuities are financial products/contracts generally sold by insurance companies to protect an investor’s assets against downside market risk and long life expectancies.

Investors have to pay premiums/fees in order to secure the guarantees.

Annuities are very important investment instruments, and can be an indispensable part of your overall investment portfolio. Keep in mind that annuities are very aggressively marketed, and it is very important to understand exactly how they work.

Not only do they have significant tax implications, but it is easy to inadvertently lock down your money for 7-10 years without really knowing it, pay a huge tax bill when withdrawing the money, or spend an exorbitant amount on various fees and expenses.

While they can be good for you, you need to know and understand what you’re getting into. Legally speaking all annuities will have a lifetime income benefit built into their contract, but, depending on the types of annuity and the preferences of the annuitant, it may never be exercised.

There are several types of annuities.

Variable annuities will offer investments in “separate accounts” which mirror mutual funds, and behave about the same. These will typically offer a death benefit protection that is at least the principal amount, but this generally comes with a surrender period of seven years or more, in which the annuitant may have to pay surrender fees for large withdrawals. Some do not have surrender periods.

Variable annuities tend to have higher fees associated with them than retail investment accounts, but this is not necessarily the case if you plan on paying a wrap fee to an advisor.

Fixed annuities come in a few forms.

There are period annuities, which can act as alternatives to CDs and other conservative investments, but, even though the rates are generally better, the funds may become “retirement assets” in the IRS’s eyes, even if they weren’t already, meaning you may owe an early withdrawal penalty for accessing the funds before age 59 ½.

Period income annuities will take a lump sum and pay it back with interest over a certain number of years, but not a lifetime.

Lifetime income annuities act like a pension and most of them are just as illiquid. Some newer versions of income annuities offer liquidity with cash and a stepped-up income basis on which the lifetime income benefit will be based if triggered.

Indexed annuities are sold as fixed products because a small portion of the investment goes into index derivative contracts which are managed by the insurance company and the investor participates in the gains to an extent.

The insurance agent selling these does not have to be securities licensed, or especially know what they’re doing with “investments,” so use caution when shopping indexed annuities.

Other developments in the industry give annuitants added pools of benefit for long term care needs. These can be variable, fixed, or indexed products, and the idea is that longevity and extended care needs go hand in hand, so these products seek to take care of both risks.

There is obviously more to it, but we’ll attempt to explain as we go.

What are the Expenses Associated with Buying and Holding an Annuity?
What Happens to My Annuity After I Die?
What are the Different Types of Annuities?

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