What is Annuity: Meaning, Types & Benefits

What is an Annuity?

An annuity is an agreement between an individual and an insurance company that ensures financial stability when the individual is no longer earning a salary. In this arrangement, the buyer makes either a lump-sum payment or a series of payments. In return, they receive regular payments in the future. Depending on the type of annuity, these payments may start right away or after a set period.

Annuities come in various types, offering flexible payout options to suit different needs. Some provide income for a fixed period, while others guarantee payments for the rest of the buyer’s life. Certain annuities even extend benefits to a surviving spouse after the buyer’s death, offering continued financial security for loved ones. These options help individuals customize annuities to align with their retirement goals and long-term financial planning needs.

Annuity meaning with example:

• At age 50, you invest ₹5 lakh in a guaranteed pension plan that begins annuity payments at 60. Over 10 years, your investment grows, and at 60, you start receiving a fixed monthly income. You can determine how much money you will receive after retirement using a retirement calculator and entering details like the accumulated corpus amount.
• You invest ₹8 lakh in a variable annuity and allocate the amount across mutual funds. Your future payments vary depending on how these funds perform.

Annuity Meaning

An annuity allows you to invest a sum of money upfront, either in a single payment or through a series of payments, and in return, you receive regular payments in the future. These payments can start immediately or after a certain period, depending on your type of annuity.

Annuity meaning with example:

• At age 50, you invest ₹5 lakh in a deferred annuity set to begin payments when you turn 60. Over the 10 years, your investment grows, and when you reach 60, you start receiving monthly payments based on the annuity’s accumulated value.
• You invest ₹8 lakh in a variable annuity, choosing to allocate your investment across different mutual funds. Depending on who well these funds perform decided your monthly payments are adjusted.

How Do Annuities Work?

Annuities aim to reduce people’s concerns about outliving their assets by supplying a steady cash flow during retirement. Some investors may purchase an annuity contract from an insurance company since their current wealth might not be sufficient to maintain their standard of living.

When you buy an annuity plan, you pay an insurance company or financial institution a lump sum or a series of payments. The annuity company invests this payment, referred to as the premium.

Your premium increases while it is being accumulated, deferring taxes. The annuity provider invests your money, and the value growth of your annuity is based on how well these underlying investments perform.

Throughout the distribution phase, the annuity provides you with regular income payments. The contract’s terms govern the payment schedule. Some annuities allow you to choose to receive income for a predetermined period, such as 10, 15, or 20 years. Alternatives include lifetime payments made as long as the recipient is alive.

Different Types of Annuities

One can choose from various annuity pension plans based on their requirements. Each plan works differently.

Life Annuity

A life annuity guarantees regular payments for your entire life. The payments stop only after your unfortunate passing, regardless of how long you live. This type of annuity is ideal for individuals who want a steady income during retirement without worrying about outliving their savings.

For instance, let’s say you invest in a ₹30 lakhs life annuity that gives monthly payouts of ₹22,000. You will receive the annuity payout after your retirement for as long as you live. If you live until 90, you will still get the payout each month. However, once you pass away, the payments stop, and your family does not receive anything further.

Life Annuity With Return of Purchase Price

This type of annuity works like a life annuity, with an added benefit: after your passing, your nominee will receive the initial investment (purchase price) you made. You can consider this option if you want to pass on some funds to your loved ones after your demise.

Referring to the above example, if you have invested in a ₹30 lakh life annuity with a return of purchase price option, you will surely receive ₹22,000 every month for the rest of your life. Additionally, after you pass away, the insurer will return the ₹30 lakhs you initially invested to your nominee.

Guaranteed Annuity

A guaranteed annuity provides regular payouts for a specific period, such as 5, 10, or 15 years. If you pass away during the guarantee period, the payments continue to your nominee until the defined term ends.

Suppose you invest in a guaranteed annuity with a 10-year term and a payout of ₹15,000 per month. If you pass away after 4 years, your nominee will continue to receive ₹15,000 monthly for the remaining 6 years. If you live beyond the 10 years, the payments will stop after the guarantee period ends.

Joint Life Annuity

A joint life annuity ensures that payouts continue for as long as either you or your spouse is alive. It is ideal for couples who want to secure income for both their lifetimes.

Let’s say you and your spouse invest ₹40 lakhs in a joint life annuity. You receive ₹30,000 monthly as long as one of you is alive. In case of your unfortunate passing, your spouse continues to receive ₹30,000 every month until they are alive.

Joint Life Annuity with Return of Purchase

This plan is similar to a joint life annuity. The only difference is that after the demise of both you and your spouse, the insurer will return the purchase price to your nominee.

Assuming the same figures discussed in the above point with reference to a joint life annuity with return of purchase, your nominee will receive ₹50 lakhs after both you and your spouse pass away. This ensures that your family (for instance, your surviving children) benefits even after your lifetime.

Fixed Annuities

As the name suggests, such a plan offers a fixed payout, which is decided at the time of purchasing this policy. It offers financial stability as the payouts are unaffected by market fluctuations.

For instance, if you invest ₹10 lakhs in a fixed annuity, the insurer can guarantee to pay you ₹8,000 every month for the rest of your life. Even if the stock market crashes, your ₹8,000 payout remains unaffected. This is an excellent choice for individuals seeking predictable and stable income.

Variable Annuities

In contrast with fixed annuities, a variable annuity involves investing your premiums in market-linked funds like mutual funds or equities. The payouts depend on the performance of these investments, making them variable. If the market performs well, your payouts increase; if it underperforms, your payouts decrease.

If you invest ₹15 lakhs in a variable annuity linked to equity funds and the market does well, you might receive ₹25,000 monthly. If the market does not perform well, your payout could drop to ₹18,000. This option is suitable for those comfortable with market risks and looking for potentially higher returns.

Taxationon Annuity

There are two aspects of annuity taxation. First is when you start contributing to an annuity during your working years. Those contributions will be deducted from your taxable income under Section 80C, 80CCC, and 80CCD (1) up to ₹1.5 lakhs.

The second aspect relates to the annuity earnings. The good thing here is that you will be liable to pay tax on these earnings only when the payouts or withdrawals begin. Thus, no tax is to be paid during the accumulation phase of the annuity, leading to tax-deferred growth.

But how are the annuity payouts taxed? They are included in your taxable income under the head ‘Salary’ if they form part of your employment benefits. Otherwise, they are included under ‘Income from other sources.’

Once you calculate your taxable income by including the annuity payouts, it is taxed as per your income slab. The different rates under both old and new tax regimes are given below:

Benefits of Annuities

Below are the advantages of each of the annuity pension plans. This may assist in determining the proper course of action to meet the subject’s monetary requirements.

Guaranteed Income Stream

An immediate annuity provides income that is smooth and without any volatility in the later stage of life, i.e., during the retirement period. Thus, this plan aims to help people maintain financial independence in their retirement age, providing them with stable earnings to pay for their needs.

Tax-Deferred Growth

One of the key benefits of annuities, particularly fixed and variable varieties, is that they are tax-deferred. Therefore, the returns on the investment are not taxed until they are withdrawn. This means the investment will also be more effective in growing over time, and the retirement fund will be better.

Flexibility in Payout Options

However, annuities have flexibility in the payout method, where people can select from the different income types. They comprise terminal payments, progressive payments, or sometimes a mix of both, allowing for flexibility to meet specific financial objectives.

Long-term Care and Other Riders

Additional riders offer even more benefits, such as long-term care coverage, which is included in many annuity plans. These riders help cover other unpredictable cost-of-living contingencies, especially in the area of health care, making for complete security in retirement.

Legacy Planning

Legacy features can also be added to annuities, enabling the annuitants to leave behind a financial body when they die. Some of the options offered by the annuity help guarantee that any remaining balance is returned to the beneficiaries, ensuring that the dependents are financially taken care of for generations.

Why Do You Need an Annuity Plan?

Here are a few reasons why you should define annuity goals for yourself and your family:

• An annuity offers you a fixed income for the rest of your life, which means financial freedom during your golden years.
• You have the flexibility to choose between monthly or yearly payouts.
• Tax benefits are based on current tax provisions.
• Tax benefits are provided based on current tax provisions.
• You can withdraw money before the surrender period ends in case of an emergency like a critical illness diagnosis.
• You can also choose to pay premiums in a lump sum or in installments, depending on your circumstances.

Who Should Buy an Annuity Plan?

An annuity plan can be a good option for people looking for a guaranteed income stream in retirement. Here are some of the people who might benefit from buying an annuity plan:

People Close to Their Retirement

Annuities are a good option for people nearing retirement age. It can provide a guaranteed income stream for the rest of your life, which can help you avoid running out of money after retirement.

People who have Just Starting Earning

Annuities can prove an excellent way for young people to save money. They can protect income and turn it into a corpus with regular payouts for later days.

People who Want Their Family to Have a Safe Future

Annuities can give your spouse or dependents a guaranteed income in case of your untimely demise.

Example of an Annuity

It becomes easier to grasp what is annuity by studying the National Pension System (NPS) in India. It is a government-sponsored retirement savings scheme that offers market-linked returns. Under the NPS, you can contribute regularly during your working years. At the time of retirement, a portion of the accumulated corpus must be used to purchase an annuity from a government-approved Annuity Service Provider (ASP).

For instance, if an individual accumulates ₹50 lakhs in their NPS account by the time they retire, they are required to invest at least 40% of this amount in an annuity. This annuity in NPS then pays out a fixed monthly income during the post-retirement years. The flexibility to select different types of annuity options, such as life annuities or joint-life annuities, makes the NPS a popular and practical example of how an annuity works in real life.

How to Buy Annuities?

Now that you have information regarding what is annuity, its various types, tax implications, and benefits, it is time to move to the final stage, i.e., buying the right plan. Buying an annuity involves several steps, and it is crucial to consider the process carefully. Here is a guide on how to purchase annuities:

Evaluate Your Needs

Determine your financial goals, risk tolerance, and how an annuity fits your retirement plan.

Research Types of Annuities

There are various types of annuities, such as variable, fixed, and indexed. Before deciding, understand their features, benefits, and potential drawbacks.

Compare Providers

Research reputable insurance companies or financial institutions that offer annuities. Compare their product offerings, fees, and customer reviews.

Understand Contract Terms

Read and understand the annuity contract thoroughly. Pay attention to payout options, surrender charges, death benefits, and potential penalties for early withdrawals.

Decide on Funding Options

Determine how you will fund the annuity. You can make a lump-sum payment or contribute through regular premium payments.

Purchase the Annuity

Once you have selected the annuity that suits your needs, complete the necessary paperwork and submit the required funds to the insurance company or financial institution.

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