What is an Annuity?

An annuity in its simplest form can be thought of as a certificate of deposit (CD) issued by an insurance company.

Two big differences; annuities are guaranteed to be paid by an insurance company instead of a bank, and annuities provide tax-deferred income. Specifically with an annuity, no income is recognized for tax purposes until you make withdrawals; however with CDs interest is taxable when it is earned.

So what are you really earning on CDs? If a CD is paying 4% and you are in a 25% combined (federal, state, and city) tax bracket, you are actually keeping only ¾ of you earnings. After taxes you are making 3% on your CDs. If you were in an equivalent annuity at 4%, none of the interest would be taxable until you withdrew the money, so you would actually have all of your interest compounding in the following year.

Annuities also have many other features that are not found in CDs, which we will discuss next.

Common Features of Annuities

All annuities no matter how complex and different they seem, will contain these common features.

Interest Method

Interest crediting methods vary widely among the different types of annuities. For example, annuities can have a stated interest rate or earn interest based on how well a stock index performs.

Death Benefit

All annuities will have some sort of death benefit or they can even have various death benefit options, which the investor selects when purchasing the annuity.

Annuitization or Payout Choices

Annuities contain payout provisions that are called "annuitization" by insurance companies.
Basically, at any time during the annuity, you can request to turn the money in the annuity into a payout plan. Payout plans can be over a fixed period of years, over the life of the individual, or can include provisions for the wife to continue to receive payments after the husband's death.

Annuitization can only occur once during the life of the annuity, and usually the choice to receive a steady stream of payments is irrevocable. This doesn't mean that you can't withdraw the money in an annuity in other ways; for example, most annuities include provisions for penalty free withdrawals or loans during the term of the annuity.

Next we'll talk about immediate and deferred annuities.

Immediate and Deferred Annuities >>