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Annuity sounds like it should be a financial code word. It should be traded with pork futures by men in smoking jackets and wingback chairs.

So here's the dirty little secret: It shouldn't. It isn't. An annuity is a financial product for the average consumer, one typically designed to help you save for retirement. This is an asset that every savings-oriented investor should have their eye on.

What Is an Annuity?

An annuity is part insurance contract, part financial product.

The basic structure of an annuity has two parts: the accumulation phase and annuitization. During accumulation, you invest as you would a mutual fund or other financial product. At a later date the contract annuitizes and begins making steady payments based on the nature of the product and your overall investment.

Most investors use an annuity to save for retirement. They make investments over the course of their working life and structure the annuity to pay them back after they turn 65. The structured nature of an annuity's returns allows the investor to use it as a replacement for a paycheck if they choose.

How Do Annuities Work?

Annuities are typically sold by an insurance company which guarantees the payments. This guarantee is why it's considered part insurance contract. Hereinafter we will refer to "management companies," however, as some annuities are sold by financial management firms as well.

The specific structure of an annuity can vary. Investors can choose products which have annuitization over a fixed term of years or which attach to specific life events (such as retirement or death). They can even choose to receive their payment in the form of a lump sum. The details of each contract depend on the specific product.

Types of Annuities

The amount your annuity pays back can change depending on how you choose to collect your return. However, there are two main types of annuities: Variable and Income (otherwise known as "Fixed").

1. Variable Annuities

A variable annuity is more like a structured mutual fund than a traditional annuity. Instead of guaranteeing a set payment, the return on this annuity returns scheduled payments based on the performance of a series of investments.

This means that you could reap potentially higher rewards if these investments do well, but also risk losing some (or all) of your money if the market fares poorly. A variable annuity exchanges predictability for potential income benefits.

A variable annuity also typically is more expensive than an IRA or 401k, which performs essentially the same function.

2. Fixed Annuities

A fixed annuity is the traditional format. In exchange for a specific investment, the institution guarantees fixed, periodic payments. As noted above, most investors use this as a supplemental retirement account due to the set and predictable nature of the payments.

Tax Advantages of Annuities

Annuities come in two taxable forms: Deferred and Immediate.

1. Deferred

Most annuities are what is known as "tax deferred." This means that the earnings of the annuity compound without paying taxes. This allows your investment to grow faster than it would otherwise. For variable annuities, this can mean a higher rate of return. For fixed annuities it can mean a higher contracted payment upon annuitization.

Further, when you receive payments from an annuity, you do not pay taxes on the amount you originally invested (your "cost").

While specific vehicles may differ, the tax advantaged annuity is intended as a retirement asset. As a result, withdrawing funds too early can incur a 10% IRS tax penalty. At time of writing that trigger age was 59 1/2. This is a general rule which the IRS applies to early distributions from retirement plans other than IRAs.

2. Immediate

A deferred annuity doesn't contemplate withdrawal for years, if not decades. An immediate annuity allows the investor to begin receiving payments within days of initial investment.

While it tends not to have the tax advantages of a deferred annuity, with the exception of cost recovery, an immediate annuity can be useful to several types of investors. Workers who are nearing retirement may invest in an immediate annuity as they will need the income soon. Investors looking to turn lump sums of cash into steady income may do the same thing, as this is often a secure (if relatively low-yield) way to ensure that a sum of cash provides long term benefits.

Liquidity and Risks of Annuities

The benefit of an annuity is financial structuring. It allows you to create a supplemental retirement account or to manage lump sums of money with the promise of future payouts. Even setting aside the risks inherent to a variable annuity, there are still some downsides, however.

Liquidity 

An annuity is a highly illiquid asset. Except for some immediate annuities most contracts begin payments on a fixed date many years in the future. If you withdraw money from an annuity before that date you usually trigger a "surrender payment." This is a fee which the management firm charges for early withdrawal. You may also, as noted above, incur a tax penalty.

Fees

An annuity is typically a fairly expensive asset. Since this is a contract, not strictly an investment vehicle, the management firm will often charge fees and commissions to buy into the annuity. This can eat a considerable portion of your initial investment, while management fees for variable annuities can run to 3%, 4% or more.

Insolvency

An annuity is a contract, not a deposit. As a result it is not FDIC insured. This is relevant because many investors are looking to hold an annuity for a period of decades or more.

This can create a risk of the company holding their contract goes under.

If the firm which sells you an annuity goes bankrupt you have no protection. You will become a creditor entitled to a share of the insolvent firm's assets, but no more than your initial investment cost (and the odds of getting that back would probably be slim). Make sure you feel good about the longevity of a firm before buying a 20-year contract with them.

Why You Should Use an Annuity

Setting aside lottery winners who need to portion out their wealth, the main value of an annuity is for savers who have hit their maximum 401k or IRA contributions. It allows you to build a tax-advantaged retirement account beyond those traditional vehicles. It also allows you to invest in an account built around replicating the structure and surety of an income.

An annuity is expensive, which is why most investors should consider their traditional retirement vehicles first. However, after those options have been exhausted, this can be a good way to begin building conservative, predictable income for the years to come.

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