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What to Ask Before Buying an Annuity

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Cameron Huddleston
Kiplinger.com
Saturday, February 16, 2008; 12:00 AM

Editor's Note: This story has been updated since it originally was published in 2002.

Heard the stories about people who are sold an annuity but later aren't sure what they've invested in?

Michael Furois, a financial planner in Chesterton, Ind., has heard plenty of complaints from clients who were sold annuities before coming to him but didn't really know what they were buying. "It's a complicated product that most people don't understand," Furois says. "If people understood the ins and outs of annuities, there would be fewer sold."

Note that it's deferred annuities -- tax-deferred products designed for retirement saving -- that create most of the confusion, not single-premium immediate annuities. Deferred annuities make sense for some people. But to be sure they're right for you, learn the answers to these questions.

How do annuities work?

An annuity is an insurance product: You make a lump sum payment or series of payments, and the money grows tax-deferred at a fixed or variable rate (the accumulation phase). In return, the insurer agrees to make periodic payments to you for the rest of your life (the payout or annuitization phase). Annuities also have a death benefit (this is where the insurance comes in) that entitles your beneficiary to the value of your annuity or a guaranteed minimum, whichever is greater.

But there are lots of twists. You can't withdraw the money until you're 59�, or you'll be hit with a 10% penalty on earnings. Plus, you'll pay a surrender fee if you tap the annuity before a certain period laid out in the contract (usually seven years).

Another drawback: Earnings are taxed as income rather than at the long-term capital gains rate. And annuities usually charge more than 1% a year for the death benefit, but it pays off only if you die when your account has fallen below the minimum guarantee.

What type of annuities are there?

There's a whole slew of annuity products, but deferred annuities fall into three main categories:

Fixed annuity. You lock in a guaranteed rate of return for periods ranging from one year to ten years. Rates can fluctuate but will never drop below your guaranteed rate. You won't lose money, but you won't have the potential for growth you'd get by investing in stocks or stock funds.

If you meet the annuity-buyer profile, a fixed-rate annuity is worth considering now -- especially if you have low risk tolerance and a shorter time horizon for when you need the money.


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