How does an annuity work?

To help you have a better grasp on annuities, let’s have a quick rundown on how they work.

In a nutshell, you’re making an investment in the annuity. You’ll then receive payments on a future date or series of dates. The income that you’ll receive from an annuity can be allotted monthly, quarterly, or annually. Or, you do have the option to receive one lump sum payment.

How do Annuities Work

How much will each payment be? Well, that depends. The size of your payments are determined by numerous factors.

How does an annuity work?

Annuity payment size depends on the following:

  • The type of annuity.
  • How much you pay for annuity premiums.
  • When you want annuity payments to start and end.
  • The interest rate that your annuity earns.

If you want a more accurate figure, there are a number of free online annuity calculators that you can use to calculate your payout.

With annuities, you have two options in regard to the length of your payment period. You can receive payments for the rest of your life or for a specific number of years. If you opted for lifetime payments, that will help ensure that you won’t outlive your assets. On the flip side, your payments won’t be as high.

Furthermore, the amount you’ll receive depends if you went with a guaranteed payout (fixed annuity) or a payout stream. The latter is determined by your annuity’s underlying investments (variable annuity) performance.

how an annuity works

Annuities explained in a little more detail.

Are you still lost? Chris Hogan, a financial expert, and bestselling author, compare this to ordering a burrito at Chipotle. “You can create an annuity based on your preferences and your own personal situation, minus the chips and guac,” he explains. “Here are the different ways you can put an annuity together.”

  • Single vs. Multiple Premiums: How do you want to pay for the annuity? If you have a large pile of money—maybe through years of saving or an inheritance—you can pay for an annuity in one big payment,” writes Hogan. “Or you can pay for the annuity with a series of payments over many years.”
  • Immediate vs. Deferred: When do you want to receive payments? An immediate annuity is self-explanatory, it’s a payment that you’ll take right now. Or, you can wait and take payments out at a later time. “Keep in mind that if you take out any money from your deferred annuity before age 59 ½, you’ll get hit with a 10% early withdrawal fee on top of the income taxes you’ll owe!” warns Hogan.
  • Lifetime vs. Fixed Period: How long will your annuity payments last for? “In addition to choosing when you’ll start receiving annuity payments, you’ll also need to decide how long those payments will last,” Hogan states. “One of your options is a lifetime annuity that will pay you a certain amount for the rest of your life.” The other choice? A “fixed period annuity that will send you payments for a set amount of time—anywhere from 5 to 25 years.”

Why do people buy annuities?

The answer is quite simple. People mainly buy annuities to help manage their income once they retire. In fact, annuities can be a handy retirement planning tool, since they can provide:

  • Periodic payments for a specific amount of time. Again, this could be for the rest of your life or a specific timeframe. Or, it can last the life of your spouse or another person.
  • Death benefits. What if you pass away before you start receiving payments? The person you name as your beneficiary will receive a specific payment.
  • Tax-deferred growth. Here’s a nice little perk. You won’t have to pay any taxes on any income and investment gains from your annuity until it’s withdrawn.

Just keep in mind that while annuities are a solid retirement option, they aren’t the best option for certain individuals, like those with high expenses. Overall though most financial planners and insurance salesmen will advise seniors or other people in various stages toward retirement towards annuities.

Let’s dig a bit deeper into the benefits of your annuity.

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