An annuity, in its most general sense, refers to an agreement where one party agrees to make a series of payments to another party. While the term “annuity” typically relates to a contract between an individual and a life insurance company, it can also involve a charity or a trust.

Annuities can be categorized based on various factors, including:

  • Nature of the underlying investment: Annuities can be classified as either fixed or variable, depending on the investment component and potential returns.
  • Primary purpose: Annuities serve different purposes, such as accumulation or pay-out. They can be further categorized as deferred or immediate, depending on when the payments begin.
  • Nature of pay-out commitment: Annuities can have different pay-out structures, such as fixed period, fixed amount, or lifetime payments, which determine how and when the funds are distributed.
  • Tax status: Annuities can be classified as qualified or nonqualified, based on the tax treatment of contributions and distributions.
  • Premium payment arrangement: Annuities can have either a single premium or flexible premium payment arrangement, depending on whether the contributions are made in a lump sum or over a period of time.
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Annuities offer several attractive features that make them appealing to individuals seeking financial stability and long-term income:

  • Tax deferral on investment earnings
    Unlike many other investments, annuities provide tax deferral on investment earnings. The growth of capital gains and investment income within annuities is not taxed until you withdraw the money. This tax advantage is similar to retirement accounts like 401(k)s and IRAs, but annuities have the advantage of no contribution limits and more flexible withdrawal requirements.
  • Protection from creditors
    If you own an immediate annuity and receive regular payments from an insurance company, creditors generally have limited access to those payments since the money now belongs to the company. Some state laws and court decisions also offer protection for annuity payments. Additionally, funds in tax-favored retirement plans, such as IRAs and 401(k)s, are typically protected from creditors, whether invested in an annuity or not.
  • An array of investment options, including “floors”
    Annuity companies provide a range of investment options. You can choose a fixed annuity that offers a specified interest rate, similar to a bank Certificate of Deposit (CD). Alternatively, variable annuities allow you to invest in various mutual funds, including stocks, bonds, and other assets. Some annuities even offer “floors” that limit investment declines by guaranteeing your investment will not fall below a certain value.
  • Tax-free transfers among investment options
    Unlike mutual funds and other investments made with after-tax money, annuities allow tax-free transfers between investment options. This flexibility is particularly valuable when implementing rebalancing strategies recommended by financial advisors. Rebalancing involves periodically adjusting investments to maintain a desired risk/return profile.
  • Lifetime income
    Immediate annuities offer a unique feature of converting an investment into a stream of lifetime payments. These payments are derived from three sources: your initial investment, investment earnings, and contributions from a pool of individuals who do not live as long as actuarial tables forecast. This pooling mechanism enables annuity companies to guarantee you a lifetime income stream.

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