Insurance

How do annuities work?

During client meetings this question often comes up. Here are the basics on how annuities work. You will quickly see why they are such a popular investment.

Basically, annuities are a kind of investment account that is issued by an insurance company. The difference from other kinds of investments is that an annuity comes with a contract. Annuities work based on the contract where the rules regarding the annuity are listed in detail. Be sure to ask to see a copy, a specimen, of a contract before purchasing and read it over carefully.

From start to finish, here is the process of purchasing an annuity and how the annuity works when you need money out or decide to leave the money in to grow in value.

1. Choose a specific type of annuity. Annuities work differently and have many options to choose from. Work with your agent or broker and give them a complete picture of your entire financial situation so they can use their experience to help you choose.

2. Fill out the paperwork. When it is finished you can send in a check for the initial investment or you can fill out the transfer or rollover paperwork to move money from another account into the annuity. Your annuity contract will be issued when the initial investment is received and the insurance company is finished processing your paperwork.

3. Taxes, pay as you go or when you need money? Annuities work by growing your money tax deferred as long as the investment inside of your annuity performs well. For a fixed annuity you might be receiving an interest rate or a return based on a market index. For a variable annuity your funds are likely invested in a mutual fund like investment that can go up and down with the market. Tax deferral simply means that you do not pay taxes until you take money out of the investment.

4. How do annuities work in regards to investment length? Annuities will keep going until you decide that you don't want them anymore by taking all of your money out. Basically they will just keep going and you can easily take what you need out each year for living expenses. Just be careful of the surrender charges you read about in your contract and work around them. Some annuities work by having a renewal at certain time intervals. Look for the renewal period with fixed options. The length then is really more dependent on the surrender charge schedule. You will pay penalties if you decide to take all of your money out before the end of the surrender charge schedule.

5. What happens when you need to taking money out? Most insurance companies offer some form of free with drawl that is available every year. These can range from 3% to 10% and may include interest earned. You will likely pay taxes on the entire amount withdrawn but check with your CPA. Principal comes out last and you will not pay taxes on your principal if your account is not an IRA. The process is simple, fill out a form that tells the insurance company how much you need and they send it to you.

6. What happens if you pass on and still own the annuity? In the event that you were to pass on and still own the annuity you heirs would get their share of the annuity. Annuities work great to pass money on as they have beneficiaries like an IRA. You choose what goes where and the money avoids probate.

How do annuities work? In my experience annuities are the simplest investments to work with because they have specific rules that are completely written out in the annuity contract. There are also hundreds of options which make it possible to choose the best option for your exact situation. Be sure to read your contract for all of the specific details on how your annuity works or request a specimen contract if you are purchasing a new annuity.