Annuities are poorly understood investment products, largely because they come from the insurance industry rather than the mainstream investment world. The basic idea is the same -- put money in, get more money out -- but annuities are more complex than many other investments because the insurance industry is regulated differently. This means there are some sharp limits on how you receive the funds. Once your annuity begins paying out, or annuitizes, that decision is usually irrevocable.
An annuity is a contract between you and an insurance company. You provide the company with either a lump sum or periodic payments, which it invests on your behalf. This can be through the company's in-house investment portfolio, or by using the annuity to hold conventional investments such as mutual funds. Payouts may begin immediately or after a specified deferral period. Depending on the structure of the contract, you may remove the funds either as a lump sum or take regular payments. This is referred to as "annuitization."
Annuities have other uses, but most commonly they are intended to provide a steady stream of retirement income. Traditional annuities include a contractually guaranteed income, while those invested in the markets pay a variable return based on the success of the investments. The income begins when the contract is annuitized and continues until its payment obligations are fulfilled. For some annuities, payouts continue only for a specified number of years. Others pay until the death of the contracted individual or a second individual. In each case, once the contract has been annuitized, there is usually no way to undo that decision.
That inflexibility is a handicap in the tightly competitive investment market, making it necessary to split your investment among multiple annuities to retain some control of your payouts. In 2010, legislation made it possible for annuities to offer a split or partial annuitization. This allows the annuitant -- you -- to receive payments on part of the capital, while letting the rest grow within the contract. This change won't affect your existing annuities, and new annuities won't necessarily reflect this change. If you want that flexibility, make sure it's available in the annuity you choose.
Of course, sometimes even a partial annuitization is more than you want. If you just need to withdraw money from the annuity to meet a short-term crisis, that's also an option, though an expensive one. Most annuity contracts penalize those withdrawals during the first seven years, imposing substantial "surrender charges" that decline with each passing year. The tax implications also can be potent. The funds within an annuity grow tax-free until they're withdrawn. Then any gain becomes taxable income at your current marginal tax rate. Even worse, if you're not yet 59 1/2 years of age, you'll pay a 10 percent penalty on the amount withdrawn.
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