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 income payments back to the investor at a specified interest growth rate. The annuity is a loan from an investor to an insurance company. In return, the insurance company pays the investor back, over time, with interest. Similar to bank CDs, insurance companies offer different types of annuities with different rates and returns on the investments.

A variable annuity offers a choice about where to invest payment(s) during the saving phase. 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 as they are affected by 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.

Approach variable annuities with caution. This type of annuity invests in sub-accounts, generally mutual funds and other investment vehicles, and their costs and fees are passed on to the annuity contract, usually 0.5% to 1.25% annually. The investor also must pay for the insurance component, called mortality and expense risk charge (M&E). The average annual M&E charge is 1.15%. These charges can create a significant negative impact on a variable annuity's return.

Annuities also incorporate stiff surrender charges. If an investor withdraws money from an annuity early, the surrender charges can be as high as 6% to 8% during the first few years of the annuity's life.

The main selling point of a variable annuity is that the underlying investments grow tax-deferred, similar to an IRA. Gains from the annuity are not taxed until money is withdrawn. With an annuity an investor can choose to have the annuity pay a guaranteed income - annuitization - based on how well the underlying investment performed, until death. This attribute is only possible with an annuity. The insurance portion of the annuity also may provide certain investment guarantees, such as guaranteeing that the full principal (amount originally contributed to the account) will be paid out on the death of the account holder, even if the market value was low at that time.

Unlike a conventional IRA, the money put into an annuity is not deductible from your taxes. The taxes are simply deferred until they are withdrawn. Also, unlike an IRA, there is no limit on how much money an investor can contribute to the annuity.

Variable annuities usually attract wealthy investors saving as much as possible for retirement. Most have already tapped out their other tax-deferred savings options. Young investors should fully fund IRA plans and any company 401k plans before looking to variable annuities as an investment option.

Variable annuities are usually very expensive. Most investors should invest in index funds, which are cheaper and also provide favorable tax benefits.

Each annuity provides two basic options: an immediate or deferred payment. An annuity with an immediate payout begins payments to the investor beginning right after the purchase, while a deferred payout provides payments at a later date(s).

With an immediate annuity, the investor pays for the entire annuity with a single payment. The annuity begins making regular, scheduled payments immediately. The most common use for an immediate annuity is to provide a guaranteed income for a retiree that is not susceptible to market risk. The investor simply takes all of the money saved for retirement and invests it in the annuity all at once.

The deferred payment annuity is a combination of retirement savings and retirement payment plan where the investor makes regular contributions to the annuity until a certain date and then receives regular payments from the annuity until death. 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.

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