What are Annuities and How Do they Work? Should you Invest in Them?

An annuity is a contract between an insurance company and a policyholder. Policyholders must make either a lump sum or instalment payments to receive annuity payments after retirement. Furthermore, the annuity can be paid immediately after the lump sum payment or after the completion of the specific period.

Read on as we dig deeper into annuities, its types, workings among other key pointers. 

What is an Annuity?

Annuity is an insurance contract in which the insurer (or financial institution) pays the invested money in the form of fixed income in the future. When you sign up for an annuity plan, you enter into a contract with the insurer. You can make a one-time payment or a series of payments through an annuity and eventually receive regular disbursements after a fixed period. 

What Are the Types of Annuities?

The primary types of annuities are listed below:

• Deferred Annuity

A deferred annuity offers annuity benefits once the accumulation period has been completed. Furthermore, you would have to specify a particular age after which you want to start receiving annuity payments from the insurance company.

• Variable Annuity

It offers smaller payments if its investments do poorly and larger future payments if the annuity investment fund does well. Furthermore, the cash flow offered by a variable annuity plan is less stable than that of a fixed annuity. However, it allows you to enjoy the benefits of high returns from your investment funds.

• Fixed Annuity

Fixed annuities allow you to receive regular periodic payments. Insurance  companies offer fixed annuities in two forms: fixed immediate annuities and fixed deferred annuities. The former provides a fixed rate right now, and the latter pays you later.

Also Read: National Pension Scheme (NPS) – How it Works, Eligibility, Types of NPS Accounts

How Does Annuity Work?

Here’s how an annuity works:

• Firstly, you must make a series of payments or lump-sum investments to the annuity plan to receive an annuity.
• Secondly, you receive the payout after a fixed period or on a series of dates in the future. The insurance company can pay the amount monthly, quarterly, annually or even as a lump sum payment.
• Your annuity depends on several factors, including the tenure of the annuity.
• You can choose to receive the annuity payouts for a specific tenure or a regular payment for the rest of your life.
• The annuity amount also changes if you have chosen the guaranteed payout (fixed annuity) plan.

How to Use an Annuity Calculator?

An annuity calculator helps you estimate the investment amount for the accumulation phase to receive the desired amount at the end of the tenure. Here are the steps to use an annuity calculator: 

• Enter your income details along with the expected income growth rate in the future.
• Enter your current age and expected retirement age. Do note, the earlier you start investing in an annuity plan, the longer you can invest resulting in potentially higher annuity during retirement.
• Next, you must enter your current regular expenses. If your costs are low, the potential for savings is high.
• Consider retirement savings with compounding benefits while planning to invest in annuities.
• Lastly, consider inflation as inflation rates have a prolonged effect on the future returns of a savings account. Inflation also increases your expenses and lowers your savings.

Tax Treatment of Annuities

An annuity comes with tax deduction benefits. The premium you pay to purchase a  plan is allowed as a tax deduction benefit of up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, 1961. 

Furthermore, the income you receive from an annuity fund is tax-deferred. It means you have to pay tax at the time of withdrawal and not while you invest in it. The annuity returns are taxed as ordinary income, unlike capital gains in mutual funds. However, you must remember that tax laws are subject to regular amendments.

How is an Annuity Contract Structured?

The annuity contract is structured as follows:

• Owner

The annuity owner can purchase and fund annuities, withdraw money, change the beneficiary, surrender the contract, pay the premiums, and make any changes before the annuitisation of the insurance contract. Furthermore, the contract owner can be anyone, including an individual, or an entity such as a trust or charity.

• Annuitant

The annuitant is insured and must be a person and not an entity. Furthermore, the annuitant can be different from the annuity contract owner; however, both are the same in most cases. The lifetime payments depend on the life expectancy of the annuitant.

• Beneficiary

The beneficiary refers to the designated recipient of the annuity policy. Moreover, the beneficiary can either be a person or an entity.

Why Should You Invest in an Annuity?

Suppose a speculator has invested his profits in an annuity policy. In that case, he may run into trouble if they have a reserve deficit during retirement or need to make a significant, unexpected expenditure.

However, there may be another financial expert who has collected a substantial enough corpus to ensure he is unlikely to encounter a deficiency. An annuity is a wise choice for such speculators due to the reliable instalment stream it provides.

When is the Right Time to Buy an Annuity Plan?

The primary goal of investing in a retirement annuity plan is to create a steady income during your post-retirement years. Thus, the earlier you start investing in an annuity, the more benefits you can receive. Here are two examples that illustrate the importance of early investing:

• Mr. X is a 50-year-old and wants to retire at 60 and invests Rs. 10 lakh in an annuity plan. After retirement, the annuity amount will be Rs. 1,08,315 annually. In case of an unfortunate event, however, Rs. 10 lakh will be paid to the nominee.
• Mr. Y purchases the same plan at age 58 and invests Rs. 10 lakh. He will receive an annuity of Rs. 69,218 annually for life. In the event of an unfortunate event, however, Rs. 10 lakh will be paid to the nominee.

Thus, the above examples show that the returns are higher when you purchase the annuity plan early.

Things to Know Before Investing in an Annuity

If you plan on investing in an annuity, here are some points you should consider before finalising your investment decision. These points shall cover both the pros and cons of investing in an annuity:

• You get a lifetime source of income.
• You have multiple options to choose from.
• You also get tax benefits under Section 80C of the Income Tax Act, 1961.
• You can also transfer annuity benefits to a nominee in the event of your death.
• Despite the many benefits, an annuity carries significant drawbacks that cannot be ignored. Annuities are complex and come with commissions, fees, and a loss of potential returns from other forms of investments.

Also Read: What is Deferred Tax? How is it Calculated?

Final Word

Annuities are not short-term investment methods but can be tailored for income or long-term gains. People who want long-term financial security, retirement income, diversification, and principle preservation will find these products appealing. 

An annuity is a flexible contract offered by an insurance provider that transforms the premiums investors pay into a fixed, guaranteed income stream. Your future annuity payments depend on the type of annuity you choose.

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