Annuities 101: How They Work

By | December 17, 2013

Preparing for retirement can be overwhelming, as there are many types of investment plans to choose from—each with unique benefits and risks. Before you commit your savings to a plan that you are uncertain about, you should learn about all of the options that are out there.

Annuities 101: How they work

Start by looking at the opportunities provided by your work and bank. Next, take a moment to learn about annuities, which are financial products purchased through insurance companies that can provide you with a steady stream of income during retirement.

Annuities provide tax advantages, leveraging the time you have between now and retirement. Many retirees choose this option to supplement other income, from Social Security, pensions and 401(k)s.

To understand how annuities work, you need to look at how income is paid out and how interest is calculated.

Income from Annuities

You can purchase an annuity with either a lump sum or a series of payments. The way you purchase the annuity will be determined in part by how much money you have available and when you want to start receiving payments from the annuity.

Are you currently near the age of retiring? If so, you likely would look to purchase an immediate annuity. An immediate annuity, purchased with a lump sum, gives you a fast turnaround on the money you put in.

Within 12 months, you will begin receiving payments. The duration of the time period for receiving payments can be anywhere from 10 years, known as a period-certain annuity, to the rest of your life, known as a lifetime annuity. The amount of your payments will be based on factors such as your age, gender and the amount you invest.

If retirement is further down the line for you, a deferred annuity may better suit your needs. You will have the option of purchasing this annuity with a lump sum or series of payments, and then the annuity will have time to grow tax-deferred. Typically, investors wait to receive these payments until after the age of 59½ to avoid IRS penalties.

Interest from Annuities

Evaluating how you want interest calculated on your annuity will depend on the level of risk you can afford to take on. The three basic ways interest is calculated are fixed, variable and indexed.

With a fixed annuity, your money builds interest based on a low-risk asset portfolio. You have a guaranteed rate of return that will never fall below a provided minimum. Although the return on this account is stable, the interest may not match the current rate of inflation.

A variable annuity allows you to choose how your account is invested, based on the stocks and bonds held by the company. While there is a higher risk with these annuities, market fluctuations can result in a higher return on your investment than would be possible with a fixed annuity.

An equity-indexed annuity has a moderate level of risk and is based on an index such as the S&P 500. Similar to a fixed annuity, these also have a minimum return guarantee.

You should be able to continue the lifestyle you have today by protecting your assets and investing wisely. Consult a financial expert to find out if purchasing an annuity will be the next step in building your retirement portfolio.



Alanna Ritchie has spent years studying, writing and learning to love the intricacies of the English language. Today, she works as a content writer for, where her primary focus is personal finance.

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