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How Do Annuities Work? The Fixed Index Annuity

However, understanding “How do annuities work?” is one of the biggest challenges most people face to actually utilizing them.

Though they are often are given a bad reputation for being too complex, they can be very helpful if you are looking for a way to make the most of your long-term savings.  In addition to creating a steady stream of passive income, they can also be used to protect your finances against market fluctuations as well as preserve your ability to continue receiving payouts.

In particular, we’ll look at something called the fixed index annuity.  This is a product that can really help maximize your returns.

But first, let’s make sure that we understand what exactly an annuity is.

How Do Annuities Work?

An annuity can be explained as an insurance contract where one or two people go into an agreement with an insurer for a chosen period of time.

In this case, you, the investor will have to invest a lump sum amount. You will make the payment to an insurance company as this is an insurance contract and thus, only sold by insurance company.

For the investment, you will receive a certain amount of income by the insurance/annuity company during the chosen time period. You have the option to receive annuity payments for your lifetime. The income that you will receive will contain both a return of principle and interest.

For example: Let’s say you invest a lump sum of $500,000 into an annuity.  An insurance company may then give you $2,830 in monthly income for the rest of your life.  As you can easily calculate, within 15 years you’ll have received more money from the annuity than if you had simply kept the $500,000 for yourself.  PLUS you get the added benefit of continuing to receive those payments for the rest of your life.

The size of your payments will depend on which type of annuity you pick.  At their core, there are three main types of annuities:

  • Fixed Annuity – It will pay out a fixed rate of return on the money that you will invest. Many people choose this as it offers a predictable and guaranteed income stream. No matter what the condition of the financial market is; with a fixed annuity you can always expect a steady income stream.
  • Variable Annuity – It will pay out a variable rate of return on the invested money. Here, the income stream will be connected (in part) to the stock market, and it will have the potential to increase if the markets increase. Unfortunately this also means it may have the consequence of decreasing if the markets decrease.
  • Indexed Annuity – It will pay out a rate of return on the lump sum money that you will invest that is tied to an economic index. In simple words, it is a hybrid of fixed and variable annuity. This is because you will receive a minimum guaranteed payment during most situations and a higher rate when the market does well.

In addition to the type of annuity you choose, you also get to pick whether you want the payments to be deferred or an immediate basis, meaning the income payouts will begin either at a later date or starting right

now.

Why Should You Purchase an Annuity?

Annuities are the perfect financial products for such investors who:

  • Want to receive truly passive income
  • Need a stream of income before some other benefit becomes available like pension.
  • Want guaranteed highest income on their investment.
  • Wish to live a worriless retired life.
  • Want a way to subsidize for early retirement.
  • Want to way to save their savings.
  • Want financial security.
  • Wants minimize tax on the invested amount.
  • Want help to fund any ongoing cost like education cost for a child.

If any of these sounds like you, then an annuity may be a good way to supplement or replace your income completely.

What is Fixed Index Annuity?

To get the best out of your invested amount, you may want to look more closely at the benefits of a Fixed Index Annuity.

Before discussing the advantages of Fixed Index Annuity. here is a short definition of it:

A fixed Index Annuity is such annuity which combines the advantages of a guaranteed interest rate with the probability to earn additional interest which will be based on the growth of an index (external).

The reason why you are getting a guaranteed interest rate is the fact that you will not actually participate in the market. So, your invested money in your annuity does not face any risk.

What are the Advantages of Fixed Index Annuity?

By combining the power of a guaranteed, fixed minimum payment AND the possibility to earn even more income if the market performs well, there are many reasons why a fixed index annuity could be one of the better ones to invest with:

  • It is a safe move to go for as you can choose from many well-known insurance companies who won’t con you.
  • Enjoy tax deferral.
  • You can participate in a portion of the gains of stock market without the risk.
  • The return will be higher than the interest rates of CDs and bonds.
  • Enjoy the benefit of death payout guarantee options.
  • Allows flexible withdrawal privileges.

Keep in mind that when we say “if the market goes up, you should receive more” that we do not mean that you would receive the full up-swing of the stock market.  It simply means that your investment would go just a little bit.

The trade-off, of course, is that you would not have to worry about not receiving a payment or losing your money if the market behaves poorly.  Because of the built-in minimum “fixed” portion, you would still receive some guaranteed portion.  That’s not a bad deal at all!

If you do decide to purchase a fixed index (or any annuity), be sure to go with a reputable and highly recognized service provider.  Speak with a customer agent on the phone and make sure they can clearly explain to you all the terms of the contract.

Also make sure the returns are clearly defined and spelled out in the contract.  Fees (including the surrender fees) are reasonable and do not put you in any sort of position to lose more money than you will gain over time.

Images courtesy of FreeDigitalPhotos.net

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