Often called do-it-yourself pensions, annuities are retirement products which can be purchased from insurance companies as a way to secure a regular income stream. They can be a great substitute for the traditional personal pension plans, but anyone desiring an annuity contract must first understand how annuitizing annuities work and their possible consequences.
Annuities can be classified as deferred or immediate. A deferred annuity is a fixed, lump sum of money which can accrue tax-deferred interest until the money is finally converted as a retirement income. An immediate annuity is also a lump sum of money, but from which the insurer has to pay a fixed and guaranteed monthly income. The lump sum is converted by the annuity into payments per month, comprising a return of principal with interest.
Annuitants — or the person collecting the annuity payments — can convert deferred annuities to immediate annuities by "annuitizing the contract."
Annuitants can choose to annuitize a contract either by a monthly income or a lifetime income. A monthly income guarantees payment for a fixed period — called a period certain — typically 10, 15 or 20 years. As its name implies, a lifetime income enables the annuitant to collect a monthly payment until his or her death — regardless of the time which has elapsed since the contract was annuitized.
Annuitants can also choose to modify their lifetime annuity payouts with either: a period certain, joint-and-survivor or refund modification. If he or she decides to add a period certain, payments will be made throughout the annuitant's life for a fixed period.
If an annuitant prefers to be paid monthly based not only on his or her own life span but also on the life span of the beneficiary, the choice can be made to have a joint-and-survivor annuity, which ensures payments until the death of both the annuitant and the beneficiary. A refund annuity, meanwhile, will guarantee the total payout will at least be equal to the original lump sum paid — in case the annuitant dies early.
Annuitizing annuities is an irreversible process. This is why those considering it as an alternative retirement plan should carefully weigh all their options. For instance, they should compare the tax benefits they can get from purchasing annuities against the after-tax return to other viable investments. Annuitants who bought annuities with some or all after-tax dollars qualify for partial tax exclusion. The exclusion ratios are provided by the insurance company together with the payment quotes, and vary with the different annuity options.
Annuity. a lump sum of money which purchases a contract from the issuer, an insurance company, and results in a regular stream of income in return for the annuity holder (annuitant).
Deferred annuity. A fixed, lump sum of money which builds through tax-deferred interest until paid out as retirement income.
Immediate annuity. Also a lump sum of money from which the insurer pays fixed and guaranteed monthly income. The lump sum is paid to the holder in monthly payments and is partially a return of principal and partially interest.
Annuitizing the annuity. This means you "flip the switch" and tell the insurer it is time to start paying you, either by monthly income or a lifetime income.
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