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What Is a Tax-deferred Annuity—Exactly?

An anonymous reader writes to us,“I've heard a lot about investing in tax-deferred annuities for retirement. But I'm embarrassed to admit that I'm notreally sure what an annuity is and how it works. Can you explain it to me in plain English?”

Don't be embarrassed, because you are not alone. Annuities are often misunderstood by people from all walks of life.

Basic premise: Briefly stated, an annuity is simply a contract between you and an insurance company or some other financial institution that provides regular payments on scheduled dates and continues for the rest of your life or for a period of years. You can pay the entire amount up front or make a series of payments to the issuer. No tax is due until payments are received.

Is that all there is to investing in annuities? Not quite. There are several variations on this basic theme. In a general sense, however, tax-deferred annuities may be divided into two basic categories: fixed and variable.

1. Fixed annuities: This annuity pays a fixed amount at regular intervals for a set amount of time. It is tied to the performance of government-backed securities and the payments are guaranteed by the issuer.

2. Variable annuities: As the name implies, this annuity invests in a wide variety of investment products. Therefore, the amount of your payments depends on the performance of the various investments. It generally offers the opportunity for a greater return than a fixed annuity but at a higher risk.

Although many conservative investors may feel more comfortable with fixed annuities, sales of variable annuities have grown dramatically in recent years. As with every investment, it is important to understand all the implications of annuities. For instance, you may find that the terms differ from one annuity to another. Also, consider any fees, commissions and surrender charges you may have to pay.

Finally, be aware that withdrawals prior to age 59½ may be subject to a 10% tax penalty. This may be an important consideration.

The Securities and Exchange Commission requires that financial institutions issuing the annuities spell out all the expenses in a standardized table near the front of the prospectus. This will enable you to uncover any unexpected fees.

Note: Although you should only consider issuers of annuities with a proven track record, be aware that past investment performance is no guarantee of future results.

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	[ return to list ] What Is a Tax-deferred Annuity—Exactly? An anonymous reader writes to us,“I've heard a lot about investing in tax-deferred annuities for retirement. But I'm embarrassed to admit that I'm notreally sure what an annuity is and how it works. Can you explain it to me in plain English?” Don't be embarrassed, because you are not alone. Annuities are often misunderstood by people from all walks of life. Basic premise: Briefly stated, an annuity is simply a contract between you and an insurance company or some other financial institution that provides regular payments on scheduled dates and continues for the rest of your life or for a period of years. You can pay the entire amount up front or make a series of payments to the issuer. No tax is due until payments are received. Is that all there is to investing in annuities? Not quite. There are several variations on this basic theme. In a general sense, however, tax-deferred annuities may be divided into two basic categories: fixed and variable. 1. Fixed annuities: This annuity pays a fixed amount at regular intervals for a set amount of time. It is tied to the performance of government-backed securities and the payments are guaranteed by the issuer. 2. Variable annuities: As the name implies, this annuity invests in a wide variety of investment products. Therefore, the amount of your payments depends on the performance of the various investments. It generally offers the opportunity for a greater return than a fixed annuity but at a higher risk. Although many conservative investors may feel more comfortable with fixed annuities, sales of variable annuities have grown dramatically in recent years. As with every investment, it is important to understand all the implications of annuities. For instance, you may find that the terms differ from one annuity to another. Also, consider any fees, commissions and surrender charges you may have to pay. Finally, be aware that withdrawals prior to age 59½ may be subject to a 10% tax penalty. This may be an important consideration. The Securities and Exchange Commission requires that financial institutions issuing the annuities spell out all the expenses in a standardized table near the front of the prospectus. This will enable you to uncover any unexpected fees. Note: Although you should only consider issuers of annuities with a proven track record, be aware that past investment performance is no guarantee of future results. [ return to list ]
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