Money Basics: What is an annuity?

Welcome to Money Basics, Yahoo Finance’s new personal finance series offering quick explanations for some of the most important terms involving your money.

If you’re planning for your retirement, you might want to consider opening an investment account known as an annuity.

A type of insurance contract, annuities can provide a steady source of income during your retirement. These contracts can supplement, or be a substitute for, other types of retirement accounts like 401(k)s or Roth IRAs.

There is no income limitation on how much money you can place in an annuity.

When you invest in an annuity, you make either a lump-sum payment or a number of payments to an insurance company. In turn, the insurance company will start making payments to you right away or at an agreed-upon date in the future.

Annuities offer a way to make a tax-deferred investment for retirement without the contribution limits of a Roth IRA. Some annuities also carry a death benefit, which sends the money in your account to a designated beneficiary if you die.

There are three types of annuities: fixed, indexed and variable annuities.

Variable annuities offer the chance to make more money on the principle based on future market performance. However, you risk making less money if the markets don’t do well and the fund suffers. Meanwhile, indexed annuities are tied to the performance of a particular stock index like the S&P 500. Finally, fixed annuities provide regular unchanging payments regardless of market conditions.

Of course, annuities come with risks and costs. The initial lump sum of money invested into the annuity is not easy to withdraw. If you take out money before a certain period of time, usually the first five to seven years, you can face stiff surrender charges. Annuities can also come with other administrative fees.

With variable annuities in particular, ongoing investment management and other fees can often add up to to 3% of the investment a year.

As with any investment, make sure you do your research to see if an annuity makes sense for your portfolio. Fixed payments in retirement can be attractive, but you should make sure you’re comfortable with the down sides of annuities before you invest in one.

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