An annuity is a contract between the annuity owner and the insurance company. It allows the owner to accumulate tax-deferred savings that he/she will use upon retirement. The annuity owner makes a lump-sum payment or a series of payments to the company, depending on the contract. In return, the insurance company makes a regular payment to the annuity owner after a due period, again depending on the annuity contract.
In the United States, only insurance companies are allowed to sell annuity contracts. Moreover, in the United States, annuity contracts are defined by the Internal Revenue Code and are controlled by each individual state.
There are three major types of annuities – the fixed, the indexed, and the variable. The first type is the one we are concerned with in this article.
The fixed annuity is the oldest type of annuity that has become available in the market. With its long history, it is considered as one of the safest investments anyone could ever have. This might be the best choice for people who do not want to risk their money in the stock market. In this type of annuity, the insurance company pays the annuity owner with no less than the rate of interest specified in the contract. This is a stable way to guarantee a dependable source of income after retirement. Although the interest rate does not increase, it does not decrease either.
In fixed annuities, the insurer guarantees to pay the annuity owner periodically with a specified amount per dollar in the annuity account. Depending on the contract, these payments may last for a specific number of years (for example, 20 years) or for the lifetime of the annuity owner or of his/her beneficiaries.
Most of the various fixed annuity types and structures are designed to provide a steady and stable stream of income to retirees. To highlight the feature of this annuity, it has often been called “retirement annuity.”
A fixed annuity is divided into two major phases – the Accumulation Phase and the Annuitization Phase.
The Accumulation Phase is the stage in which the annuity owner gives regular payments to the insurance company for the premium of his/her annuity account. In some cases, annuity owners build up the value of their account for several years. In other cases, annuity owners may give the payment for their account value in the form of a lump sum payment that essentially qualifies as the entire accumulation phase.
The Annuitization Phase is the stage after the premium on the annuity account has been completed. In this phase, the annuity owner can begin to collect his/her regular payments from the insurance company. The amount of income collected or withdrawn will be subject to tax.
Fixed annuities are very low-risk investments. Fixed annuity rates generally fall into the 1% to 4% range. Compared with the interest rate in money market accounts, this range of interest rate is way higher. This rate, however, is lower than the interest rate typically offered by mutual funds, which can be as high as 10%. You have to keep in mind, however, that mutual funds do not guarantee a fixed interest rate and a stable source of income. Thus, investing your money in a fixed annuity is still a better option if you want to prepare for your retirement and if you are a conservative investor who does not want to gamble his/her money in market conditions that tend to fluctuate.
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