If you're like most people, you've probably hear the of annuities but aren't exactly clear on what they are. Well, I'm here to demystify them for you. This article will explain the basics and make some recommendations about buying annuities to plan for your future.

What Are Annuities?

Annuities are contracts with insurance companies that obliges them to make payments to you. These payments are typically disbursed monthly until a fixed amount has been reached or a specified period of time has passed.

There is, however, quite a bit of variety when it comes to annuities. The period of disbursement can be anywhere from a single payment to the length of the annuitant's life. The payout can also begin immediately or at some point after you purchase the annuity. Your fees, moreover, can be paid in a single lump sum or dispersed over time.

Types of Annuities

Fixed Annuities

Fixed annuities are the most stable and predictable. You pay a certain amount to buy one and in turn you are guaranteed a fixed payout over a fixed period of time.

The payout can be deferred until you retire, until any time that you choose, or can begin immediately. Deferred annuities accrue interest at levels typical for certificates of deposit (CDs) or perhaps a bit higher.

Advantages

  • Interest rates are guaranteed
  • Investment minimums are low (often as low as $1,000)
  • Interest is not taxed until the money is paid out

Disadvantages

  • Interest rates sometimes drop after the first year
  • Heavy surrender charges apply if you have to withdraw your money early
  • Since the payout is fixed, it decreases in value over time due to inflation

Who They're Suited For

Fixed annuities make sense if you're concerned that your savings and whatever pensions you might have will not see you through your old age and you want a to collect a payment that will at least cover your basic expenses (for helpeful financial advice, see these Top 25 Personal Finance Bloggers to Follow on Twitter).

Variable Annuities

Variable annuities are similar to fixed, with one significant exception: instead of a guaranteed payout, the payout depends on the performance of investments that you choose. You select the investments from a basket of those offered by the insurer (usually stock, bond, or mutual-fund-like portfolios). As with fixed annuities, the gains aren't taxed until withdrawal.

Advantages

  • If your investments do well, your principal can grow
  • The value of your annuity might grow faster than inflation

Disadvantages

  • If your investment does poorly, your principal will shrink
  • Long-term capital gains are taxed at ordinary income tax rates, which are higher than capital gains tax rates
  • Commissions for purchase can be as high as 4%, and management fees can run to 2% to 3% per year

Who They're Suited For

Variable annuities might be a good idea if you have maxed out your 401(k) and IRA contributions.

Equity-Indexed Annuities

Equity-indexed annuities give you a guaranteed return, usually 2% to 3%, and a possibility of a higher return if the stock market rises, as the return on the annuity is tied to the performance of an index such as Moody’s, Fitch, or Standard & Poor’s.

Advantage

  • Combines a guaranteed minimum payment with the possibility of receiving more

Disadvantages

  • Complex, with different methods for determining gains in the index, often with caps and with the dividends usually excluded when determining performance
  • Huge surrender charges if you want to cash in early

Who They're Suited For

Indexed annuities are for those who want to play the stock market with a little less risk than actually buying stock. They are for people who have extra money that is not essential for their retirement plans.

Immediate Versus Longevity Annuities

Any of the three types of annuities described above can be immediate or longevity annuities.

Immediate annuities are those whose payout begins immediately upon your investment in the annuity.

With longevity annuities, on the other hand, your payout will be delayed until an agreed-upon time (usually when you reach 80 years of age). By deferring your payments for so long, you allow the principal to grow and can significantly increase the amount you'll receive every month. If you anticipate living to a very old age and you are concerned about exhausting other investments, this method will ensure that you have funds at your disposal in your twilight years.

Of course, not everyone lives to be an octogenarian. And even if you live to your very early 80s, your investment might be higher than your payout. At least with immediate annuities, you are far more likely to recover the investment you put into them.

Invest with Care

Annuities can be complex. Before investing, discuss your financial needs with a registered broker (see What Is an Insurance Broker to learn more about what they do). Make sure to understand what you're up against with respect to fees and tax consequences, among other things. Invest with care.