How Does An Annuity Pay Me An Income?How An Annuity Turns Savings Into A Paycheck.

What Is An Annuity, In Plain English?

The California Department of Insurance defines an annuity as a contract between you and an insurance company. You buy it with one premium payment or a series of them, and the insurer makes income payments to you, for life or for a limited time. Most people who buy one want an income when they retire.

The money you pay in is your principal. What you get back depends on the contract’s terms: how it credits interest, when payments start and which payout option you choose. Each of those is a decision you make before you sign, which is why the contract deserves a slow, careful read.

How Does An Annuity Turn Savings Into Monthly Income?

Once income starts, you are in what the California Department of Insurance calls the amortization period. The insurer pays you, and each payment can include both principal and interest. The period can last as long as your life, and even your beneficiary’s. You choose how payments end:

• Life annuity: income for life, and payments stop when you die.
• Life annuity with period certain: income for life, and if you die before a set point, your survivor receives income for a limited time.
• Joint and survivor annuity: income for life, then a portion, such as 50% or 75%, continues for your survivor’s life.

What Is The Difference Between A Fixed And A Fixed Indexed Annuity?

Both are insurance contracts, and the difference is how interest is credited. With a fixed annuity, your money earns interest at rates set by the insurance company, and a rate may hold for one year or up to 10 years, with a minimum rate written into the contract. A fixed indexed annuity, which the Department calls an equity-indexed annuity, has an interest rate usually based on a stock market index.

The Department flags three details to watch: contracts with a minimum interest rate of 0%, a higher first-year teaser rate that drops later, and advertised rates that aren’t guaranteed. Ask what the minimum rate is and how long any higher rate lasts, and get both answers in writing.

What Are Surrender Charges, And How Long Do They Last?

A surrender charge is the penalty for taking money out of a deferred annuity early, during its accumulation period. The California Department of Insurance notes you can’t take money out in the first year. After that, some contracts let you withdraw part of your money without a penalty, but larger withdrawals can cost enough that you end up with less than you put in.

Before you buy, get three answers in writing: the surrender charge for early withdrawals, how long the surrender period lasts and how much you can take out without a charge. Ask, too, whether your beneficiary would pay a surrender charge if you die before income starts. If you might need the money during the accumulation period, the Department’s advice is to skip a deferred annuity.

Who Guarantees The Income From An Annuity?

The insurance company that issues the contract. Every guarantee in an annuity, including lifetime income, rests on the financial strength and claims-paying ability of that insurer. The California Department of Insurance suggests checking the company’s financial strength ratings from independent rating organizations before you buy.

The Department also notes that annuities usually carry commissions and other fees, and that they typically earn less than stocks and bonds. An annuity is a long-term contract, so weigh its payments, its charges and the insurer behind it with the care you would give any decision that is hard to undo.

How Are Annuity Payments Taxed?

A deferred annuity delays taxes: you generally pay nothing until you receive income payments. Payments are then taxed as ordinary income. If you bought the annuity with pre-tax dollars, the whole payment is taxable; if you used after-tax dollars, you pay tax only on the interest.

Taking money out before age 59½ can bring a tax penalty, with exceptions such as disability or a move to another annuity. You can move money between annuities without paying taxes, but the Department cautions that a replacement can bring new fees and penalties, and the agent earns a commission. Your CPA should run the numbers for your situation.

Is An Annuity Right For My Retirement?

The California Department of Insurance suggests four questions, and says that if you answer no to any of them, an annuity is probably wrong for you. Maartin can walk through them with you, then show where an annuity would sit beside Social Security and your other savings. The decision stays yours.

• Can I afford to tie up my money for many years?
• Will I have enough money left to have an emergency fund, such as a bank account?
• Will I have enough money left for my long-term care and other health care needs?
• Can I cover my expenses until I start getting income payments?