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What is an Annuity?
An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future.
The goal of annuities is to provide a steady stream of income during retirement. Funds accrue on a tax-deferred basis, and like 401(k) contributions, can only be withdrawn without penalty after age 59.5.
Many aspects of an annuity can be tailored to the specific needs of the recipient. In addition to choosing between a lump sum payment or a series of payments to the insurer, you can choose when you want to annuitize your contributions – that is, start receiving payments. An annuity that begins paying out immediately is referred to as an immediate annuity, while those that start at a preset date in the future are called deferred annuities.
Breaking Down Tax Deferrment
By deferring taxes on the returns of an investment, the investor benefits in two ways. The first is tax-free growth. Rather than paying tax on the current returns of an investment, tax is paid only at a later date, leaving the investment to grow unhindered. The second benefit of tax deferral extends to investments made during pre-retirement periods when earnings and taxes levied against working wages are typically higher than earnings in post-retirement phases.Withdrawals taken from tax-deferred investment accounts occur when a person is earning less taxable income and the tax rate realized by an individual is usually lower than the rate applied during the employment phase.
Tax Deferred Annuity Types
A fixed annuity is a type of contract that guarantees to return both the investor’s principal plus a fixed rate of interest. These contracts essentially function much like Certificate of Deposits (CDs), except that they grow tax-deferred.
An indexed annuity is a special class of annuities that yields returns on contributions based on a specified equity-based index. These annuities can be purchased from an insurance company, and similar to other types of annuities, the terms and conditions associated with payouts depend on what is stated in the original annuity contract.
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