An annuity is a contract between you, the purchaser or owner, and an insurance company, the annuity issuer. You pay money to an annuity issuer in its simplest form, and the issuer pays out the principal and earnings back to you or a named beneficiary. Life insurance companies first developed annuities to provide income to individuals during their retirement years.

One of the attractive aspects of an annuity is that its earnings are tax-deferred until you begin to receive payments back from the annuity issuer. In this respect, an annuity is similar to a qualified retirement plan.

Over an extended period, your investment in an annuity can grow substantially more significant than if you invested money in a comparable taxable investment. Like a qualified retirement plan, a 10 percent tax penalty may be imposed if you begin withdrawals from an annuity before age 59½. However, unlike a qualified retirement plan, contributions to an annuity are not tax-deductible, and taxes are paid only on the earnings when distributed.

Four parties to an annuity contract

There are four parties to an annuity contract: the annuity issuer, the owner, the annuitant, and the beneficiary.

The annuity issuer is the company (e.g., an insurance company) that issues the annuity.

The owner is the individual or other entity who buys the annuity from the annuity issuer and contributes to the annuity.

The annuitant is the individual who will stand in as the measuring life for the contract. Essentially, this makes them the person whose own expected life span will determine the timing and amount of distribution benefits paid out. The owner and the annuitant are usually the same person but do not have to be.

Finally, the beneficiary is the person who receives a death benefit from the annuity at the passing of the annuitant.

Two distinct phases to an annuity

There are two distinct phases to an annuity: (1) the accumulation (or investment) phase and (2) the distribution phase.

The accumulation phase is the period when you add money to the annuity. If you use this option, then you’ll have purchased a deferred annuity. ’You can purchase the annuity in one lump sum (known as a single premium annuity), or you can make investments periodically over time.

In contrast, the distribution phase is when you begin receiving distributions from the annuity. You have two general options for receiving distributions from your annuity. Under the first option, you can withdraw some or all of the money from the annuity in lump sums.

The second option (commonly referred to as the guaranteed income or annuitization option) provides you with a guaranteed income stream from the annuity for your entire lifetime (no matter how long you live) or for a specific period (e.g., 10 years). (Guarantees are based on the claims-paying ability of the issuing insurance company.) You can elect for this option at any time on your deferred annuity. Or, if you want to invest in an annuity and start receiving payments within the first year, you’ll purchase what is known as an immediate annuity.

In addition, you can elect to receive the annuity payments over both your lifetime and the lifetime of another person. This option is known as a joint and survivor annuity. Under a joint and survivor annuity, the annuity issuer promises to pay you an amount of money on a periodic basis (e.g., monthly, quarterly, or yearly).

The amount you receive for each payment period will depend on how much money you have in the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin the annuitization phase. The length of the distribution period will also affect how much you receive. Suppose you are age 65 and elect to receive annuity distributions over your entire lifetime. In that case, the amount you will receive with each payment will be less than if you had elected to receive annuity distributions over five years.

When is an annuity appropriate?

It is important to understand that annuities can be an excellent tool if you use them properly. Still, annuities are not right for everyone.

Annuity contributions are not tax-deductible. That’s why most experts advise funding other retirement plans first. However, if you have already contributed the maximum allowable amount to other available retirement plans, an annuity can be an excellent choice. There is no limit to how much you can invest in an annuity, and, like other retirement plans, the funds are allowed to grow tax-deferred until you begin taking distributions.

The bottom line

Annuities are designed to be very-long-term investment vehicles. In most cases, you’ll pay a penalty for early withdrawals. And if you take a lump-sum distribution of your annuity funds within the first few years after purchasing your annuity, the issuer may impose surrender charges. Nevertheless, as long as you’re sure you won’t need the money until at least age 59½, an annuity is worth considering. If your needs are more short-term, you should explore other options.

Regardless of your investment goals, you may find it beneficial to enlist the help of a financial advisor. They work closely with clients of all backgrounds to establish a solid financial plan. That includes budgeting, savings, and estate planning, depending on their background. Navigating annuities alone can overwhelm. But with a financial advisor on your side, you can ensure that your annuity meets the features you