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How do annuities work?

An annuity could be a valuable addition to your retirement plan. Here's how they work.

Couple reviews annuity information.

A paycheck for life

Sometimes referred to as a retirement annuity, a life annuity or annuity insurance, an annuity is an insurance contract you purchase that guarantees you'll receive a specified amount of money every month for the rest of your life, no matter how long you live.

One way to think about annuities is that they kind of provide the opposite type of protection as life insurance. Most people buy life insurance in case they die too soon, while annuities provide a safety net for living a long life, which many people find very comforting. As we get older, nobody wants to stress at each passing birthday - happy to be alive, but worried about running out of money. An annuity can help ease those concerns.

The following information pertains to fixed annuities only. Variable annuities work differently and have an investment risk component.

Annuities 101

At its core, an annuity is a savings option for retirement. It provides a way for you to save money on a tax-deferred basis and receive a steady income in retirement that you can't outlive. It's a contract between the owner of the annuity and the company issuing it. You buy the annuity and the company pays you interest on the money. At a certain age you start taking the money out and you could receive payments for as long as you live.

Types of annuities

State Farm® annuities are purchased with one single premium, and there are two main types:

  • Immediate Annuities generate income immediately after purchase.
  • Deferred Annuities allow your investment to grow tax-deferred until you decide to start receiving income payments at some point in the future.

Annuities have two phases.

  • Accumulation phase: The accumulation phase is the period of time after you purchase your annuity and before you start receiving payments. During this phase, your investment will grow at a guaranteed minimum interest rate. This growth is tax-deferred for annuities purchased outside of a qualified retirement plan, like an IRA or 401(k).1
  • Annuitization phase: The annuitization phase is when you start receiving payments, typically at retirement.

How do annuities pay out?

When you purchase annuities, there are a number of choices for the payout period.

One option may be the cash refund option. With this option you'll receive payments for the rest of your life. And if you pass away before getting your initial principal back, the difference will go to your beneficiary as a lump sum payment. This guarantees the return of principal. On the flip side, if you're still living once your initial investment has been paid out to you, you'll still continue to receive the same monthly payment for however long you live.

Life income annuities with period certain options are popular, too, where if you pass away before the period certain, your beneficiary is guaranteed to receive payments for the number of years you chose. If you live past that date, you'll still continue to receive payments for the rest of your life. An example might be a 10-year option where you'll get payments for life no matter what. But if you pass away before 10 years are up, your beneficiary will receive payments for the remaining time.

What is a retirement annuity?

Some people refer to annuities as retirement annuities because they're commonly used as part of an overall retirement plan. Knowing how much money you'll need in retirement can be a tricky question since we don't know how long we're going to live or what kind of health conditions we may or may not experience. So an annuity can provide a way to supplement your Social Security and other retirement savings.

What is a life annuity?

Annuities are also often referred to as life annuities because they provide you with a guaranteed income for life. A major concern people have about retirement is running out of money. An annuity can ensure you will never outlive your money in retirement.

What is annuity insurance?

Annuity insurance is another way annuities are described. And that's really the basis of what an annuity is — a very simple insurance contract whose main purpose is to protect you from outliving your income.

Why buy an annuity?

You think you might like to travel extensively in retirement? How about purchase a new car every few years? Use your annuity payout instead of taking the money from your stock market account.

Annuities are also great for people who are not very risk tolerant and want a safe place for their money to grown with some form of guarantee that you won’t outlive your money in retirement.

Get started today

If you're interested in learning more about an annuity and how it could fit into your future goals, talk with your local State Farm agent.

1Federal income tax-deferral is provided by the tax-qualified retirement plan. No additional tax-deferral is provided by an annuity.

The information in this article was obtained from various sources not associated with State Farm® (including State Farm Mutual Automobile Insurance Company and its subsidiaries and affiliates). While we believe it to be reliable and accurate, we do not warrant the accuracy or reliability of the information. State Farm is not responsible for, and does not endorse or approve, either implicitly or explicitly, the content of any third party sites that might be hyperlinked from this page. The information is not intended to replace manuals, instructions or information provided by a manufacturer or the advice of a qualified professional, or to affect coverage under any applicable insurance policy. These suggestions are not a complete list of every loss control measure. State Farm makes no guarantees of results from use of this information.

Neither State Farm nor its agents provide tax or legal advice.

Please consult your tax, legal, or investment advisor regarding your specific circumstances.

State Farm Life Insurance Company (Not licensed in MA, NY or WI)
State Farm Life and Accident Assurance Company (Licensed in NY and WI)
Bloomington, IL

Each insurer is financially responsible for its own products.


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