We make sound investments to achieve our financial goals depending on our needs and ambitions. There are different types of investments where one can invest directly or indirectly. These include bonds, mutual funds, stocks, cash equivalent investments, etc. An annuity is one type of tax-deferred investment option available. So this article delves into the characteristics of an annuity, how it works, and its pros and cons.
WHAT IS AN ANNUITY?
An annuity is a series of payments or a fixed sum of money paid periodically at equal intervals. It is a long-term contract between a customer and their insurance company where they either pay a lump sum of money or periodic payments. And in return for this, you receive regular disbursement immediately or over a period of time. In other words, this is one of the many ways of investing one’s money. This financial product is customizable keeping in mind one’s needs and requirements.
HOW DOES IT WORK?
Annuities are designed for people to have a retirement income and help grow the same. There are different types of annuities. These include variable, immediate, fixed, and fixed indexed annuities. Variable annuities are where your payments are directed to different investment options and the same will fluctuate on the basis of the investment performance and market. Immediate annuities convert a large sum into a steady, guaranteed stream of income. Insurance companies give fixed annuities for a minimum guaranteed rate of interest for a fixed amount of payment. Finally, fixed indexed annuities are the type of annuity where your principal investment is protected and there is a guaranteed special interest rate.
As discussed above, firstly, one has to invest a lump sum or invest monthly. Then, you start getting the payments/ returns immediately or at a later stage. And you get to choose the kind of returns you prefer from the different types of annuities. A good investment is one that protects you from the risk of losing or outliving your income.
Know More – Advantages and Disadvantages of Life Insurance
ADVANTAGES OF ANNUITY
Among the many advantages of an annuity is the sense of security it furnishes. Basically, you put aside a sum of money based on your convenience, and in return, you either get monthly payments or a lump sum amount. So, this means that there is a guaranteed return on your investment. In addition, the insurance company figures out the least risky option for you so the investment is protected and safe.
Another great advantage of annuities is that it is a tax-deferred investment. These are investments such as dividends, capital gain, interest, etc. These investments accumulate without taxes until the investor takes hold of the profits. In simple words, an investor has to pay taxes on the withdrawn money or funds. So, a person with an annuity has some relative control over how and when their taxes are paid.
This investment provides death benefits to the beneficiaries of the investor. In other words, it is a safety net for both you and your loved ones. An annuity protects the investor and his beneficiaries during their lifetime. After the demise of the investor, the beneficiaries still have the protection of the contract. So, they can either continue with the death benefit amount or withdraw the lump sum amount as a full payout. Hence, it is good protection for the investor’s family.
Investing in the form of annuities means that you as an investor are in control. They are customizable long-term investments. In other words, they are flexible in nature. The investor decides how the payment is to be made, the type of annuity, how the money is received by them, and how to plan the withdrawals. Hence, annuities give us flexible timing and opportunities.
Another important aspect of annuities is that it provides valuable opportunities. These include legacy planning, lifetime income, and spousal support. Legacy planning helps in increasing the benefits available to your loved ones apart from the standard death benefit. An investor can get lifetime income at no additional cost with the option of annuitization. Spousal support or opportunity deals with providing cover to one’s spouse with lifetime income benefit or death benefit.
Know More – Advantages and Disadvantages of Mortgage
DISADVANTAGES OF ANNUITY
A major drawback of annuities is that it comes with a heavy price tag. Especially when you compare it with other types of investments such as mutual funds. Based on what kind of annuity you opt for, there will be different sets of fees to be paid. These include high commissions, fund management fees, surrender charges, penalties, etc. Many annuities come with riders of additional guarantees but with a fee. Hence, one has to be very careful about choosing their type of investment. Do consult your insurance company before making a choice.
Annuities have slower growth in comparison to the stock market. And the major reason for that is the annuity fees that have to be paid. Basically, you invest your money. Then the insurance company caps your gains to a certain limit as the participation rate. So even though your money/ fund is increasing steadily, it isn’t increasing as well as other investments. You could even miss out on returns.
Lack of Liquidity
Liquidity is the availability of the liquid assets whereby an investor can sell or buy an asset without causing any changes to the properties or price of the said asset. This is not possible with an annuity. It is a strenuous process if an investor wishes to back out of a contract prematurely. They cannot do so unless a fine or a surrender fee is paid. And this fee is usually quite costly to discourage investors from terminating the contract early.
Another disadvantage of an annuity is that you cannot make any withdrawals without attracting a penalty. If you choose an investment, you have to stick to it no matter. Unless you are willing to shell out some more money. In simple words, you will be fined. So, an annuity may not be a good option for you if you need short-term payments or if you need access to your principal on short notice.
Even though annuities are a tax-deferred mode of investment, it certainly has some issues. Since it defers taxes, you do not pay your tax during the growth phase of the annuity. But this does not mean that you are absolved from paying it ever. What this means is that the disbursement or the withdrawal of the amount will be taxed, probably more than other kinds of investment. So these are eventually subject to income tax. It is only deferred for some time.
In conclusion, one should thoroughly research what the best option is for you as an investor. Once that is done, you can make sound investments and successfully grow your income.