There are various kinds of annuities. They all take the form of a contract between an insurance company and the owner or owners of the annuity policy. One choice is the fixed or guaranteed annuity where the insurance company pays a specified rate of interest to the owners based on the premium submitted. This arrangement may be in the form of an immediate annuity or a deferred annuity. The first will begin payout "immediately" (within twelve months) and is often a 'single premium policy'. In other words the purchaser writes a check for the total cost of the policy in exchange for a 'good' rate of return in the form of regular checks from the insurer. The other more common approach is for the purchaser to make regular payments to the insurance company in expectation of future benefits. There are lots of 'bells and whistles' that can be attached to all annuity arrangements. Examine them carefully as some may be more useful to you than others. Regardless, each one has a cost.

There are things to watch for: The rate of return that the salesman is representing may have caveats attached that make the rate of return less than it would seem. A high rate of return may be limited to just one or two years and then float, so you now take the interest rate risk. (The guaranteed rate cited deep in the policy is often very low.) Generally, higher returns come with longer penalty periods. Understand this provision well. Remember that the fixed income guarantee is backed only by the insurance company and should it 'go under' as some have, no one else will step in to secure what is owed you.

Sometimes the insurance company's projected rate of return are unrealistically high. This representation may some day come back at you when the company asks for more cash after you thought is was all paid for. This is not to say that a fair and sound annuity policy should not be part of your overall financial plan. It can be a stable investment, providing you with income for as long as you live, and eliminating the possibility of you 'out living your income'. One safeguard is to select a very long lived we think 100 (year old company).

What about the "deferred annuity" concept which applies to all forms of annuities? The concerns and benefits cited above are essentially the same as an 'immediate' annuity. In the deferred annuity, payments to you do not begin until after 12 months or even years later. The income taxes on gains are 'deferred' until money is withdrawn. The longer you wait to start a withdrawal plan, the greater the principal and the greater your benefits.

So far we have discussed a fixed annuity which can be immediate or deferred. A variable annuity (VA) is an annuity that allows the purchaser to allocate his or her contributions to a variety of sub-accounts, which in many ways are similar to mutual funds. Instead of paying a stated rate, the variable annuity's return is based on the performance of the sub-accounts the purchaser selects and may be changed without fees and is tax free. Variable annuities may be either flexible pay or single premium products. If the insurance company gets into financial trouble, your money is not directly effected as the sub-accounts are holding your funds. Note the difference here between fixed guaranteed and variable. An insurance company providing a fixed return is the guarantor the variable holding is at risk with the sub-account selections you have made.

Equity-index annuities

The equity-index annuity is a fairly new player on the scene. It offers to place your money in an equity index to take advantage of the growth of the stock market, most often the S&P 500. The insurance company generally offers a minimum guaranteed return. One we know of will guarantee all your money backs in ten years; others offer a small percentage increase guarantee. Always check the status of your account for those in-between times because there may be no such guarantee in place until the end of the contract period, should you want out prior to the specified date. Also, check for maximum return. It is likely that only 80% of what the market makes in a give year is added to your account value. Also look for a maximum annual return limit specified in the contract even if the market makes a substantially greater return that year, your return is limited to the contract amount. These annuities provide the same tax deferral provisions as the other annuities discussed. One provision not previously mentioned for all annuities is that they do not need to be probated and distribution of assets will be dispersed per the will provisions in the contract. Annuities also offer some protection against lawsuits.

Note that the income you receive from any of these annuities is taxed at ordinary rates. This means that you pay taxes on this income as if it were wages, or rent income instead of the advantaged capital gains. This can be a significant factor, especially in retirement and when considering social security benefits. See the Taxes section.

Annuitization is the changing of the status of your annuity into a form where the annuity becomes the property of the insurance company and in exchange the company guarantees you an income for life. This applies to fixed, equity-index, and variable annuities. They all include this election provision and in some States a requirement, that by a certain age, you must annuitize the contract. Annuitization is an irrevocable option to receive periodic payments.

The deferred contract for Annuitization may be referred to as; the contract maturity date, annuity start date, or maximum deferral date and probably states no later than a certain age, likely age 85. The maximum annuity start date may also be governed by state law.

Should you annuitize? Maybe? The insurance salesman is going to suggest that it is a good idea because he/she will get another commission for the Annuitization. What actually happens is that when you annuitize, you sign over all the value of your policy to the insurance company, which in turn provides you a fixed income for the rest of your life. There are lots of provisions to be elected by you having to do with such things as; if you die next year, who will get all the remaining money? Generally the more restrictions you elect to insure more money remains for the family, the lower the payout. Which, 'by the way' starts out at a fairly low rate of return on the value of your investment, but it does guarantee a return for your life time.

Taxation can be an issue in deciding to annuitize or not. After age 59½ , money paid to you without Annuitization is taxed as earnings first, and your principal last. (All the profits are paid first for tax purposes so this income is fully taxable until all your gains are exhausted.) If you annuitize, it is prorated between gains and principal contributed. An example of an annuitized payout with a $75,000 investment and a $25,000 gain and a $1,000 payout would show for taxes as $750 return of capital (non-taxable) and $250 gain to go on your tax return as ordinary income. This application can be a real benefit to the annuity holder.