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What Are Annuities And How Do They Work?

What Are Annuities And How Do They Work?

An annuity, in its most simple terms, is a contract taken out between an insurer, which is normally an individual, and a Life Insurance company that agrees to pay a fixed amount of interest back to the insurer a over a period of time. There are many different types annuities each with their pluses and minuses and tax implications. It is important to understand these differences when determining if getting an annuity is appropriate for your investment goals.

The most common use of an annuity is used to supplement income later in life as part of the estate planning. Individuals who are retired and are not happy with the current yields on their investment portfolio may shift into an annuity to generate additional monthly income in addition to Social Security and pension benefits. Most investment accounts such as IRAs and brokerage accounts can be under the umbrella of an annuity contract.

Types of Annuities

Of the many different types of annuities the three most common are fixed annuities, variable annuities and immediate annuities. If the insurer is younger than retirement age it may be appropriate to purchase a variable annuity as it provides flexibility in how the funds can be invested such as the stock market. Fixed annuities have less flexibility but pay a fixed amount which may be better for individuals seeking a constant stream of income. An Immediate annuity is when individuals have a lump sum of money which is signed over completely to an insurance company who then pays a certain income over a period of time.

Tax Considerations

There are certain tax implications which should be considered in deciding to invest in annuities for individuals. Some annuities provide the accumulation of funds which is tax deferred and not subject to Federal income tax. Even though annuities are most often used to provide a stream of income that is not always the case. Deferred annuities have become more common because of the tax deferred status and individuals may use these types of annuities to accumulate funds rather than receive payment.

Investment Risks

As with any investments there is always the risk of losing principle and research should be done into the financial institutions overall health when choosing an insurance provider. Annuity contracts which are governed by state law are protected against insolvency up to a specific dollar amount, often $100,000. Make sure that the amount invested in an annuity is not so high that it is not covered should the insurance company go under.


With all the annuities mentioned it is very important to speak with a license financial or investment adviser or other financial professional to make sure what is being purchased is in line with the investors risk aversion and financial goals. Annuities can be a great way to accumulate wealth or provide income later in life but they are not for everyone. Annuities should be part of a well balanced investment portfolio to protect against unforeseen market turmoil and not a single source of income.