An annuity is a financial instrument that has similar features of a savings account or a certificate of deposit (CD). To create an annuity, you must enter into a contract with an insurance company to deposit an amount of money into an annuity fund. This could be a lump sum or several payments over time. There are different types of annuities that offer different benefits and payment options. Annuities are also tax deferred.
There are two main types of annuities that have different features and rules. These two types of annuities are:
- Fixed Annuity: You earn a fixed amount of interest over the course of your annuity. You will receive a payment each year that is a set amount. In order for this to work, you will need to make payments to your annuity. This could include one lump sum when setting it up or a few payments throughout the lifetime of the annuity. Some other features of fixed annuities include the following:
- Earnings generally do not vary with the stock market or economic conditions. What this means is if the market drops, this will not affect your payment. Say you are supposed to receive $5,000 each year — this will stay the same even during poor stock market or economic conditions.
- Since these annuities are safer and carry a lower risk, you do not have the potential to make as much profit as you could with a variable annuity. It is a good choice if you want to have a predicted payment each year.
- Variable Annuity: You will not receive a fixed payment each year. Instead, your money will be invested into various securities/investment funds that the insurance company manages. Your payment amount and timeline will be based on how these investments perform. Some other features of variable annuities include the following:
- Since earnings vary with the market, that will affect the value of your annuity. This means that some payments could be higher than others.
- You can choose how much risk you want with a variable annuity since there will be different types of investments to choose from. Keep in mind that while risky investments could have a huge payoff, they could also result in large losses.
Keep in mind that these are just the two main categories of annuities that broadly encompass many different annuity programs. For example, one way to set up your annuity is as an “equity indexed annuity”. With this, your money is invested into an index of stocks, such as the Dow Jones Stock Index or the S&P 500.
This way, your earnings will likely vary with the whole market as opposed to individual stocks. This option is kind of in the middle of the two, as your earnings will vary more than with a fixed annuity, but less than with a variable annuity.
You can choose to set up your annuity with immediate or deferred payments. This will dictate when your annuity starts making payments to you.
With an immediate payment plan, you will need to give the insurance company a lump sum up front so payments can begin immediately. Many older people who are retired choose this option to receive an immediate and steady stream of income.
With a deferred payment plan, you will need to pick at time specified in the future where the insurance company will begin making regular payments to you for as long as your annuity contract states. The money you deposit in the annuity will earn interest over time, which is untaxed. At the time of payment, the interest you earned will be taxed. If you want to withdraw money from your annuity before your payments are supposed to start, you will have to pay a penalty fee.
If you die before your annuity starts paying out, then your beneficiary can either receive the cash value of the annuity or take over your payments. Your contract will determine what happens if you die after your annuity has started to pay out.
While you may not need an attorney to actually set up an annuity, it would not be a bad idea to hire one for this process. Annuities can be used for several different purposes and the features will vary, depending on your situation and what you are looking to accomplish. As such, a local business or tax attorney could help you make the best choice when setting up your annuity.
Additionally, if you or your beneficiary has a conflict with the insurance company that sold you your annuity, you may need to go to court. A common issue is non-payment of the annuity according to the contract’s terms. Understanding your annuity contract and laws relating to it can be very difficult. A qualified attorney will have an easier time explaining to you exactly what your annuity contract means for you and your loved ones. Additionally, an attorney knows your state's laws and has experience dealing with insurance companies.