With an annuity, you pay a sum of money now and you receive a larger sum later. That larger sum won't just appear out of thin air. Your principal -- the money you put in -- will be working hard to drum up profit for you. And since you'll be getting principal back, you can thank it yourself.
To understand what happens to your principal in an annuity, it helps to follow along with an extremely simple example. Say you buy an annuity for $10,000, and you will receive three equal payments in yearly installments -- one year, two years and three years from now. The size of your payments depends on the return promised by whoever sells you the annuity (usually an insurance company). Say the seller promises you a 15 percent annual return on the money in the annuity. In such an annuity, each payment will be $4,379.77, for a total of $13,139.31. Of that amount, $10,000 will be your principal returning to you. The extra $3,139.31 is the return your principal worked so hard to get for you. (Thanks, principal!)
While you're off living your life during those three years. Your principal earns a 15 percent return every year. At the start, you put in $10,000. In the first year, that grows by 15 percent, or $1,500, to $11,500. Now you take your first payment of $4,379.77 -- your 15 percent in earnings, plus $2,879.77 of your principal. That payment drops your principal balance to $7,120.23. In the second year, that amount grows 15 percent to $8,188.26. You take your second $4,379.77 payment, which brings the principal balance down to $3,808.49. Finally, in the third year, that grows 15 percent to $4,379.77 -- which just happens to be enough for your final payment. Your principal has all been returned to you, plus profit.
How It Grows
The return in an annuity comes from investments. The insurance company that sells you the annuity takes your principal and invests it in stocks, bonds, pork bellies, whatever it thinks will earn an adequate return. If the seller of the annuity is guaranteeing you a return of 15 percent, chances are that your principal is actually earning more than that and the seller is keeping the difference. Well, that's OK. The seller is in business to make a profit, after all. Besides, if the investments are dogs, the seller is still on the hook for your guaranteed 15 percent return.
The example is just an extreme simplification. Real annuities have all sorts of options. In a variable annuity (as opposed to the fixed annuity used in the example), your payments will depend on actual investment returns. In a lifetime annuity, you get payments until you die, so you may not get all your principal back. In deferred annuities, payments don't start right away, so your principal has more time to grow. The point remains the same, though: Your principal earns a return, and your payments typically include some principal and some profit.
With you making mad cash from your annuity, Uncle Sam is going to come sniffing around looking for his cut. You have to pay taxes on the investment profits you receive -- but remember that your payments aren't all profit. A big chunk is simply your principal coming back to you. That portion of the payments isn't taxed. When you're receiving payments from an annuity, you'll get statements telling you how much you've gotten back in principal and how much you've received in investment returns.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.