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What Are Annuities & How Do They Work?

Donny Gamble
February 11, 2022
what is an annuity
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Annuity income looks great on paper, but many of us fail to realize just how complicated an annuity can really be. Just what are they, and how do they work?

An annuity is a retirement account that operates on insurance programs instead of individual investment accounts. In an IRA, which is one of the most popular retirement accounts, you can buy and sell stocks, gold, and other assets within the account, like a tax-deferred bin to dabble in different investments.

An annuity is a contractual obligation. In short, you provide a large lump sum of money to an insurance company, and they make small intervals of payments to you for the duration of the contract.

They use the lump sum of money you provide to fulfill their own obligations to clients, or to continue selling investment products. The goal is that they provide you with interest during these small repayments, so your repayments over a period of time will result in a greater sum than what you provided in the beginning.

It’s a basic principle of investing, but it can also be upsetting to invest in an annuity and not receive the return that you expected. If the insurance market changes, your profit margin can change as well, and you want to make sure it stays above inflation prices.

These are some of the most important things you need to know about an annuity before you get started with one.

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3 Major Rules of an Annuity Agreement

Annuities have a ton of individual rules spread throughout, all depending on what insurance company you go through and the stipulations of the current market.

However, there are three constant, major rules that apply to nearly all annuities out there.

1. You Can’t Just Cancel an Annuity Because You Want to

An annuity is a contract, meaning you are obligated to uphold your end of the bargain. Insurance companies use the money for various business expenses and expanding their own business, so when you pull your annuity money out, they have to give you their liquid cash to make up for it.

If they pulled that money out of the actual investments, it would hurt their company and make everyone else in the same annuity program suffer. Because of this, they incur harsh penalties so they don’t disrupt their own business/operations.

You can’t just decide to back out of a contractual obligation and then walk away unscathed. It’s going to come with penalties, and in some instances, the inability to ever hold an annuity with that company again.

2. Withdrawals Are Completely Taxable

Just like with other retirement account types, when you pull money out of your annuity, it’s going to cost you. That means when those intervals come in and you receive money, there’s tax on it just like you would incur with a weekly paycheck.

It’s difficult to factor everything in when you begin an annuity, because in the time that you spend on it, you could be in a new job with a higher income, or your financial priorities could change entirely.

Just be sure that you’re aware of all the implications of your situation and possible future situation when you sign up for an annuity.

Keep in mind that your payment and taxation will be different for a deferred annuity versus an immediate annuity. It all depends on the time frame.

3. You Can’t Withdraw Money on a Whim

You put in that money, and now it belongs to the annuity. They are contractually obligated to pay it back with interest, but you aren’t entitled to that money anymore.

Instead, the money you receive will go into a tax-deferred account that you can use to invest in an IRA or hold onto as liquid cash. But it’s still all inside of a retirement account, so even once the monthly payments are yours to control, it’s still subject to early tax withdrawal in many situations.

The money that you put into the annuity isn’t just something you can take back out whenever you want.

Is an Annuity a Good Investment?

As with any investments for your retirement, we suggest having a diversified portfolio. One sector of that diversified portfolio can absolutely be annuities, but it shouldn’t be your primary focus.

An annuity is a good investment option for individuals with steady income that they can reliably control. If you can see yourself running into a situation where you desperately need the money in an annuity, then it isn’t a good investment for you at this time.

You should bulk up other sections of your portfolio before focusing on an annuity. If you need access to liquid cash, having a dissolvable asset like stocks, cryptocurrency, or an REIT is a better option until your wealth allows you to sign up with annuities later on down the line.

Summary

Annuities can be excellent investment options, but you have to be careful of predatory practices. You shouldn’t use any money that you could see yourself needing between now and when the annuity terms would end, because you can’t just take money out of there whenever you want.

At the end of the day, an annuity should be a supplement to an existing portfolio, but they are not the first investments you should see yourself making for your retirement.

Annuity FAQ's

How is an annuity different from a savings account?

In short, an annuity is an insurance product, and other retirement account forms (401(k), IRA, Roth IRA, etc.) are investment accounts. They operate differently because you can sell the assets in your IRA whenever you want, but in an annuity, you’re locked into a contract. 

Neither have one specific advantage over each other in terms of growth or growth speed. Instead, they grow money in different ways (through insurance programs) and require less hands-on work, but at the end of the day they both use tax-deferred income to fund in the beginning.

What are the downsides of annuities?

Annuities are complicated by design. If you understand the financial workings of an annuity and you can use money that you don’t need to access right now, then you can utilize annuities to help you out immensely with income streams in the future.

However, nobody sees life-changing events around the corner, so sometimes these annuities act against your current interests and you have to remove money from them at a huge penalty.

Annuities can be great, but the practice can also feel predatory (when in reality it mostly comes down to a lack of preparation before signing up for one).

Some companies use annuities in sleazy ways to try and bring on low-budget or low-income clients to receive additional fee money down the line, so you have to be careful which annuity program you sign up with.

Annuities are also not guaranteed, so you may not grow your money as quickly as you would like to, or as quickly as your friend who suggested annuities to you in the first place.

Can I sell an annuity?

Yes, in many instances, you can sell your annuity back to the financial institution that you purchased it from, although there are a lot of hoops to jump through here and you should be careful about how you proceed with this option.

On top of that, there’s going to be a few penalties here and there depending on what insurance company you signed up with and what their terms were.

However, it’s still a possibility if your financial situation or life priorities shift at all.

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About the author 

Donny Gamble

I’m Donny. I’m a world traveler, investor, entrepreneur, and online marketing aficionado who has a big appetite to compete and disrupt big markets. I thrive on being able to create things that impact change, difficult challenges, and being able to add value in negative situations.

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