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What is an Annuity?

An annuity is a type of asset. It is a contract between you and an insurance company which pays you a series of payments over time. You purchase an annuity in exchange for a guaranteed income stream in the future.

You can buy in an annuity contract in a single lump sum or make payments on it over time. In exchange for those payments the insurance company agrees to make future payments to you starting at a date in the future.

An annuity will increase your net worth but you have to take the opportunity cost into account of alternative investments. You can often hold less complicated and more flexible investments and receive better returns.

Categories of annuities

There are a plethora of different annuities contracts out there but in general there are two major types of annuities.

  1. Deferred – Payments won’t happen until later in the future. You might purchase one of these on installments.
  2. Immediate – Payments begin very soon after you make you first payment. These are typically bought with a lump sum. You might purchase one of these at retirement using cash from a stock sale.

Types of annuities

There are generally two types of annuities. They are:

  1. Fixed – Payments are fixed and specified up front in the contract.
  2. Variable – Payments fluctuate based on market performance. Part of a variable annuity payment may be fixed which would provide some protection against a major recession.

Taxes on annuities

Typically your investment into an annuity will grow in a tax deferred manner. You will pay income tax on it once you start receiving payments however.

Conclusion

Annuities are often very complicated contracts and generally not a great idea for your average investor. They are generally difficult to get out of if you change your mind.

If you are considering an annuity I’d recommend you do your homework on it thoroughly before signing. Make sure you compare different alternative investments before you decided. Annuities typically come with a significant opportunity cost as compared to other investments with higher yields, so make sure the benefits are worth it.

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