What is an Annuity?

An annuity is a contract between an investor and an insurance company. The investor makes a payment or series of payments to the insurer. In return, the insurance company makes guaranteed, scheduled payments back to the investor at a specified interest growth rate. Similar to bank CDs, insurance companies offer different types of annuities with different rates and returns on the investments.

A deferred annuity is a combination of retirement savings and payment plan. The investor makes one lump payment or regular contributions to the annuity until a certain date. This period is called the accumulation phase. After that date, the investor receives regular payments until death. This period is called the payment phase. Sometimes there is a life insurance component added so that if the investor dies before annuity payments begin, a beneficiary gets either a lump sum or the scheduled annuity payments. People saving for retirement who want a guaranteed, regular income starting at a certain date generally use deferred annuities.

All earnings in a deferred annuity are tax-deferred, which means there are no taxes paid on the earnings until the money is withdrawn. Amounts withdrawn prior to age 59.5 are generally subject to a 10% federal income tax penalty as well as ordinary income taxes.

There are two basic types of deferred annuities: fixed and variable. A fixed annuity pays a set, contracted interest rate. A variable annuity varies with the particular investments the annuity is tied to, which may fluctuate over time.

Fixed deferred annuities guarantee a specific interest rate for a set period of time. The earnings grow tax-deferred until withdrawals begin. The interest rate may change periodically, but the issuer usually guarantees the interest rate will never fall below a minimum contracted rate. Fixed deferred annuities begin with a single payment or multiple payments over time.

A variable annuity offers a choice about where to invest payments. The options provide a range of different investment vehicles, typically mutual funds. The rate of return on the payments and the amount earned varies depending on the performance of the investment options selected. Variable annuities can provide higher returns than a fixed rate account, but the returns are not guaranteed. The amounts allocated to the variable funding options of the account balance are subject to market fluctuations. In the long-run, this risk isn't that great, but it does exist, and the initial investment may be worth more or less than the original value. Many variable annuities also offer a fixed rate account. Earnings grow tax-deferred until you begin to withdraw them. Variable deferred annuities can begin with a single payment or multiple payments over time. Generally, most people contribute to the account over time.

During the saving and investing phase, assets accumulate for potential growth. A fixed deferred annuity generally offers guarantee of principal and a guaranteed interest rate for a set period of time by the issuing insurance company. Variable deferred annuities offer greater growth potential and investment flexibility with a full range of funding choices, often with a fixed interest account, but they tend to be more expensive options.

During the payment phase, there are a variety of options for the timing of income. An investor can choose systematic withdrawals, take income as needed, or convert the sum into a series of steady income payments - called annuitizing. An investor can choose to receive these payments for a set time period or arrange a guaranteed income for life.

Most variable deferred annuities provide a guaranteed death benefit that provides beneficiaries a steady, stable income. Many variable annuities also offer death benefits that increase over time, based on the annuity's value. As with most annuity products, there are a variety of options, depending on an investor's particular circumstances.

Visit http://www.annuity.com or http://www.insure.com. Talk to a tax professional and be sure to fully understand an annuity's annual fees and expenses before investing.

For more information on individual annuities, visit Vanguard, Fidelity, or T. Rowe Price. These mutual fund companies also sell annuities and generally have better annuity products than the annuities offered by insurance companies.

The Securities and Exchange Commission provides an excellent overview of variable annuities: http://www.sec.gov/investor/pubs/varannty.htm