3/27/2017

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Annuities

Four Main Kinds
by Jim Schlagheck

Let's become familiar with the main kinds of annuities and some basic annuity jargon. There are four principal kinds: (1) immediate, (2) deferred, (3) fixed, and (4) variable. Don't be put off by the terminology. These kinds of annuities are actually quite straightforward. You might want to think of them in this matrix way:

Immediate: With an immediate annuity, you typically turn over a lump sum of money to an insurer and it begins to pay you monthly, quarterly, or annual payments. The payments typically begin within thirteen months of your annuity purchase. Hence, this instrument is called immediate because its payments to you usually begin shortly after or immediately after you fix the contract.

When people retire and are ready to begin drawing down their 401(k) and IRA savings, many convert the proceeds into an immediate annuity. They "annuitize" their 401(k) and IRA money to begin income payments right away.

To annuitize means to convert cash, an investment account, a 401(k) or IRA, or some other kind of annuity into an immediate annuity, kicking off immediate income payments. You yourself may consider buying an immediate annuity one day with the proceeds of your 401(k) or IRA. But whatever you do, get professional advice before drawing down or transferring your 401(k) or IRA money to avoid tax complications.

Deferred: A deferred annuity is different. With a deferred annuity, you pay a limp sum or make periodic payments into the annuity, but only begin receiving income payments at some later time.

For example, suppose you are thirty-five years old today. You might decide to begin funding a deferred annuity and continue doing so for the next fifteen years until you turn fifty. Buy you might also opt--when you first set the annuity contract--to only have your annuity initiate income payments to you when you turn sixty-five. In other words, a deferred annuity permits you to "defer" the time when the income payments actually commence.

You can also opt for "fixed" or "variable" kinds of annuities.

Fixed: When you buy a fixed annuity, you are buying a preset stream of fixed income payments. When you sign the annuity contact, the amount and dates of such fixed payments are locked in. You cannot usually change them. (There are exceptions, but right now it will be easier for you to associate the term fixed annuity with locke-in, fixed income.)

As a rule, fixed annuities are low-risk investments that are substantially immune from market turbulence. You do not have to make any investment decisions. The income you receive is preset. However, the returns on a fixed annuity are slim. In recent years, fixed annuities have typically paid annual returns of about 3 to 6 percent per annum after expenses. You can often--but, of course, not always--do much better with a stock market investment.

In other words, you have peace of mind with a fixed annuity but often earn smaller returns.

Even so, a fixed annuity is one of few products in the financial industry that guarantees you preset income for a specific period or for life. If you buy a fixed annuity, you'll know the specific amount of income you are going to enjoy for the rest of your life or, if you choose, for some shorter period. That is an outstanding feature.

Variable: A variable annuity gives you fluctuating returns and the possibility--but not guarantee--of achieving more income from your investment. It has both upside and downside potential.

With a variable annuity, you can invest in different mutual funds--just as you do in a 401(k) plan-- and may achieve higher-than-fixed-annuity results. The income payments you receive will vary depending upon the performance of the funds you choose.

Many financial planners like variable annuities because, although the income payouts are not guaranteed, they give you access to stock market returns, have historically surpassed the returns of most other kinds of investments.

With a variable annuity you can usually invest in a mix of different stock, bond, and other funds. These funds are called subaccounts in annuity lingo. They are simply kinds of mutual funds. You can change the specific funds you invest in. You can change how much money you allocate to different funds. You can make these investment changes without adverse tax consequences. Your gains grow tax-deferred. And you may, in fact, achieve stronger annuity income depending on the performance of your investments.

But heads up! You also run the risk of investing in funds that may not, for any number of reasons, perform well. Your variable annuity income could actually produce income streams that are lower than expected because of poor performance.

So let's recap. A fixed annuity gives you fixed income payments, and you will never lose money with one unless the insurance company goes bust. A variable annuity gives you income payments that vary according to the performance of your annuity investments, and you could lose money or earn stronger returns. A fixed annuity entails less risk; it gives you "sure thing" preset rates of return. A variable annuity entails more performance or market risk, but--if you're fortunate and invest skillfully--may deliver higher income payments. The trade-off is between sure-thing financial security and larger income potential.

This excerpt and more important information about investing can be found in the book, Cash-Rich Retirement by Jim Schlagheck.

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