Most investors share the same goal of long-term wealth accumulation. But some have no problem watching their investments bounce up and down from day-to-day, while risk-averse investors or those nearing retirement generally can't tolerate much short-term volatility within their portfolios. If you are this type of investor—or one who has a low to moderate risk tolerance—annuities can be a valuable investment tool.

Key Points

• Investors typically purchase annuities to provide a steady income stream during retirement.
• Immediate annuities and deferred annuities are the two major types of annuity contracts.

• Tax benefits include tax-deferred growth, but you pay income taxes on the money withdrawn. 

An annuity is a contract between you—the annuitant—and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides akind of retirement-income insurance: You contribute funds to the annuity in exchange for a guaranteed income stream later in life. Typically, annuities are purchased by investors who wish to guarantee themselves a minimum income stream during their retirement years.

Most annuities offer tax advantages, meaning investment earnings grow tax free until you begin to withdraw them. This feature can be very attractive to young investors, who can contribute to a deferred annuity for many years and take advantage of tax-free compounding in their investments.

Because they are a long-term retirement planning instrument, annuities typically have provisions that penalize investors if they withdraw funds before accumulating for a minimum number of years. Also, tax rules generally encourage investors to prolong withdrawing annuity funds until a minimum age. However, most annuities have provisions that allow about 10% of the account to be withdrawn for emergency purposes without penalty.

How Annuities Work

Generally speaking, there are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.

With an immediate annuity, you contribute a lump sum to the annuity account and immediately begin receiving regular payments, which can be specified, fixed amount, or variable depending upon your choice of annuity package. The payout will not change for the rest of your life.

Typically, you would choose this type of annuity if you have experienced a one-time payment of a large lump sum, such as lottery winnings or an inheritance. Immediate annuities convert a cash pool into a lifelong income stream, providing you with a guaranteed monthly allowance for your old age. Sometimes people close to retirement purchase these with some portion of their retirement savings to add to their guaranteed income in retirement.

Deferred annuities are structured to meet a different type of investor need—to accumulate capital over your working life to build a sizable income stream for your retirement. The regular contributions you make to the annuity account grow tax-sheltered until you choose to draw an income from the account. This period of regular contributions and tax-sheltered growth is called the accumulation phase.

Sometimes, when establishing a deferred annuity, an investor may transfer a large sum of assets from another investment account, such as a pension plan. In this way, the investor begins the accumulation phase with a large lump-sum contribution, followed by smaller periodic contributions.

Tax Benefits of Annuities

Annuities offer several tax benefits. In general, during the accumulation phase of an annuity contract, earnings grow tax deferred. You pay income taxes when you start taking withdrawals from the annuity.

If you contribute funds to the annuity through an IRA or another tax-advantaged retirement account, you are also usually able to annually defer taxable income equal to the amount of your contributions, giving you tax savings for the year of your contributions. Over a long period of time, your tax savings can compound and result in substantially boosted returns.

It's also worth noting that since you're likely to earn less in retirement than in your working years, you will probably fit into a lower tax bracket once you retire. This means you will pay less in taxes on the assets than you would have had you claimed the income when you earned it. In the end, this provides you with even higher after-tax return on your investment.

In Summary

Annuities offer tax-deferred growth, which can result in significant long-term returns if you contribute to the annuity for a long period and wait to withdraw funds until retirement. You get peace of mind from an annuity's guaranteed income stream, and the tax benefits of deferred annuities can amount to substantial savings. Like any investment, it's important to understand how they work before adding an annuity to your retirement portfolio.