What is an Annuity Contract?

Brenda Scott

An annuity refers to a series of regular payments made to a person over a set period of time. An annuity contract is a financial product purchased from an insurance company. The annuitant, or purchaser of the contract, invests a certain amount of money, either in a lump sum payment or through a series of payments. In exchange, the purchaser will receive a return of his investment with earnings at a later date through regularly scheduled payouts.

Annuities can be a great supplement to a retirement plan.
Annuities can be a great supplement to a retirement plan.

There are a several kinds of annuity contracts. Deferred annuities are purchased as a long-term investment. The purchase price is invested by the company and is repaid in regular increments starting at some later date, usually upon retirement. An immediate annuity contract is purchased with a lump sum of cash, with payouts beginning in one year. These payments continue for the life of the annuitant, and are often purchased by retirees who are interested in a guaranteed income.

Tax-deferred annuities are purchased with pre-tax funds.
Tax-deferred annuities are purchased with pre-tax funds.

Tax-deferred annuities are purchased with pre-tax funds. In the US, this can be set up as an Individual Retirement Account (IRA). The UK offers a citizen who has reached retirement age and has a qualified pension the option of taking a tax-free, partial lump-sum distribution. This can also be used to purchase an annuity contract. In most cases, the annuity payments under these plans will be considered ordinary taxable income.

An annuity contract can also be bought with after-tax funds. When the annuitant receives his payments, the portion that is considered a return of the investment is not subject to tax. The insurance company predicts how many payments are expected to be made for each annuity, based upon the life expectancy of the annuitant. By multiplying this number with the amount of each payment, an estimate can be made of the expected total payout. The ratio between the expected lifetime payout to the amount invested is the same ratio used to determine how much of each payment is taxable.

A fixed annuity contract guarantees a set amount of money for monthly payments to the annuitant for life. That amount is based upon the purchaser’s investment and his life expectancy at the time he is scheduled to begin receiving payments. The insurance company is free to invest the funds in whatever manner it wishes. If the investment loses money, the annuity payments still stay the same, and the insurance company absorbs the loss. If the investment earns more than the lifetime payout, then the insurance company keeps the gain.

Unlike the fixed annuity, a variable annuity contract does not guarantee a set payment amount. In this investment vehicle, the purchaser assumes the risk. His payment is tied to the performance of the funds in which his annuity is invested. While the variable annuity has a greater potential for gain, it also has the greater risk for loss. As a result, it should only be considered for long-term investment purposes.

While annuities can be a great supplement to a retirement plan, no one product is appropriate for everyone. Prior to purchasing an annuity contract, an investor should carefully assess his needs and risk tolerance. Consulting with a financial advisor, preferably one who is not receiving a commission to sell a particular product, can be of great help in navigating the sometimes confusing world of annuity contracts.

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