How Do Annuities Work?

Before deciding to buy an annuity, it is important to know exactly how they work. There are three parties involved in an annuity contract: The purchaser of the annuity or owner, the annuitant whose life determines the income payments from the annuity and the beneficiary who receives the assets or remaining payments if the annuitant and/or owner dies. The owner and annuitant may be the same person but the beneficiary is almost always different.

A deferred annuity is a simple contract in which the contract owner buys an annuity from an insurance company in return for interest on the principal. The money grows, much like a savings account. In the case of an immediate annuity, the contract owner is paid a monthly income after the purchase of the annuity which lasts for a specified period of time, or for life. A deferred fixed annuity policy earns a fixed rate of interest that accumulates on a tax-deferred basis. Annuity proceeds are generally not subject to probate as well.

During the accumulation period of an annuity, there are usually withdrawal privileges available. Depending on the annuity, you may be able to withdraw 10% of the accumulated value of your annuity each year. There are federal income tax penalties for withdrawals taken before age 59½, and annuities are subjected to early withdrawal charges if more than the permitted amount is withdrawn.

The payout period is the phase in which the owner/annuitant starts receiving income from his or her annuity contract. The owner/annuitant can start receiving steady income for life or for a fixed number of years according to the selected payout term. There are many additional payout options available to match any type of individual need.