Annuities are widely misunderstood by the general public. After you read this, you will have the basic understanding of annuities.
First of all annuities are tax deferred. This means that money withdrawn is taxable in the year it is received. Also, like retirement plans, money withdrawn from an annuity, before age 59 1⁄2, is subject to IRS penalties, but certain exceptions do apply. But it is important to note that they do not apply to your original principal.
Like all other vehicles you park your money in, annuities have what is called surrender penalties, whereas mutual funds have fees, for example. Almost all annuities charge a surrender penalty if the policy is cashed in prior to the end of the surrender period. Surrender periods can vary from one year to twenty years. These penalties do not usually apply if the policy is cashed in due to death of the owner or if the policy is annuitized. Just a note, annuitized simply means setting up an income for a specified period of time, or for the rest of your life.
To keep it simple, you have two choices when it comes to annuities, fixed or variable. Fixed annuities provide a minimum guaranteed return. For example, you may get 5% for at total year, and at the end of that first year, your rate could go to 7% for the following year. Also note that all fixed annuities have a minimum rate, for example 2-3%. Fixed index annuities give you the opportunity of a fixed rate, plus the option of different index accounts.
Variable annuities can offer guaranteed returns, along with separate accounts invested in stocks, bonds, or mutual funds. Unlike fixed and fixed index annuities, your variable annuity can lose value.
Although this is a basic overview of how annuities work, understand they all have different options, and you need to choose the one that is best for you.