What is the Purpose of an Annuity?

Retirement planning can be accomplished in many ways, using many different planning and investment tools.  If you have already started considering your plan for retirement, you may have become acquainted with the term “annuity.”  An annuity is much like life insurance, but in reverse. But what is the purpose of an annuity, when it comes to retirement planning?

What exactly is an annuity?

While a life insurance policy pays out upon the death of the insured, an annuity pays while you are still alive.  An annuity is simply a promise to make a series of payments for a certain period of time, or until the occurrence of a predetermined event.  Annuities are sometimes used in legal settlements.  In fact, structured settlement annuities have been around since 1983.  In the area of investments, annuities are most commonly used for retirement planning.

The purpose of an annuity

Historically, annuities were used by life insurance companies because they allowed those companies to circumvent the risk of a policyholder outliving their established income source.  Since then, annuities have developed into great tools for retirement and investment in general.

More specifically, annuities are often used to help individuals pay for long-term medical care or disability. Another very common use for annuities is as a tax shelter for the wealthy.  For some, whose income is too high to use an Individual Retirement Account.

Different types of annuities

Basically, there are two categories of annuities: tax-deferred annuities and income annuities.  The purpose of an income annuity is to provide a steady income source during your retirement years.  A tax-deferred annuity, on the other hand, is meant to accumulate your savings during your lifetime, to be used during retirement.  Both types of annuities have their own advantages.

How a tax-deferred annuity works

Many clients become concerned once they realize they have made the maximum contributions they can to their 401k or IRA, but still need to increase their retirement savings.  In those situations, one of the best things to do is establish a tax-deferred annuity.  There are no contribution limits, and you have the option of both fixed and variable investment options, depending on your needs.

The most important benefit of a tax-deferred annuity, however, is the fact that you do not pay taxes on the income earned by the annuity.  This income can then be converted into an income annuity when you retire.

Variable versus fixed deferred annuities

With a variable annuity, the income is based on the performance of the stocks or bonds used for the investment.  So, you are subject to a certain degree of risk.  The advantage is that, variable annuities offer a better opportunity for increased long-term return.

A fixed annuity, however, is similar to a Certificate of Deposit or CD.  The rate of return is guaranteed for a specified period of time.  The benefits of this type of annuity may be better suited for conservative investors. The only real disadvantage of a fixed annuity is that the money is not insured by the FDIC, unlike a CD.

If you have questions regarding annuities, or any other retirement planning needs, please contact Sexton, Bailey Attorneys, PA online or by calling us at (479) 443-0062.