What Are Annuities?

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An annuity is a type of insurance product that is often used to help retirees receive steady income once they've stopped working. Once you invest in an annuity, you will receive payment later on that can be arranged a variety of ways, such as monthly or even in a one-time payment. If this is a tool in which you are interested, check out these four tips below for more information.

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Retirees
Many people who buy annuities are between the ages of 50 and 70 years, according to Genworth Financial, which sells annuities.

Fixed index annuities are ideal for people who want to guarantee income in their retirement for both an owner and a spouse. One member of a retiring couple with a retirement plan will typically use it to fund an annuity for the duration of either person's lifetime.

Payments
Eric Henderson, Nationwide Financial's senior vice president of individual products and solutions, says the differences among the types of annuities are mostly based on when the payments begin and the way in which the money is invested.

As far as payments go, there are two main types of annuities: deferred and immediate. With a deferred annuity, you make one or more investments before you retire. The money grows tax-deferred, meaning you don't have to pay taxes on it until it is withdrawn. On the other hand, the insurance companies will start with your payments right away if you decide to buy an immediate annuity and invest a large sum at the beginning.

However, current tax laws state that you may get hit with an additional 10 percent tax if you get your payment from your deferred annuity before age 59 and a half. Once you have reached the minimum age and start to withdraw money, your earnings will be taxed as income.

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How much do you get with each of these payments? There are two main types of deferred annuities: fixed and variable.

"The growth of a variable annuity varies, based on the market performance of its underlying investments, while the growth of a fixed annuity is pegged to an interest rate similar to a certificate of deposit or a bond," Henderson said.

Risks
Matt Grove, vice president at New York Life, says investors can create a pension-like stream of income using a deferred annuity.

"Rather than exchanging years of service to an employer to receive a paycheck in retirement, which is how traditional pensions work, consumers can fund something similar with this 'do-it-yourself' approach," Grove says.

However, there are still risks involved with annuities. As the U.S. Securities and Exchange Commission points out, the value of your variable annuity account may decrease if the mutual fund that you invest it in performs poorly. Another factor to take into consideration is your confidence in your insurer's ability to hold up its long-term end of the bargain. You should also take the charges and fees that can reduce the value of your account into consideration.

Ask about the fees associated with the annuity, as they vary by product, Henderson says. In addition to the aforementioned surrender charges, which you may incur if you withdraw money before you are 59 and a half, you may pay investment fees and mortality and expense risk charges.

Be Cautious
"Annuities are ripe for fraud," warned John Egan, the managing editor of Bankrate Insurance. "Check with your state insurance department or state securities board to find out whether someone selling annuities is approved to sell them and is in good standing with state regulators."

The AARP advises comparing the benefits and costs of an annuity with other options like savings accounts or investments. If you do decide that you want an annuity to be part of your retirement plan, you should compare the different kinds of annuities to find the best option.