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Taking Care of Mom and Dad: Annuities

Another option is for your parents to annuitize the cash value of their policies. This can be done either according to annuitization guidelines within the existing policy or by converting the cash value into a stand-alone annuity contract.

Annuities play an important and growing role in the life insurance market. They are a special form of insurance that combines elements of basic insurance and fixed-income invest-ment -- and offer some tax advantages. Strictly speaking, they are not life insurance contracts, but they often are sold by life insurance companies and agents.

Life insurance is designed to protect against the risk of premature death. You may have heard annuities described as upside-down life insurance. From the insurance company's standpoint, an annuity presents the opposite mortality risk from life insurance: Life insurance pays a benefit when someone dies; an annuity only pays a benefit if someone or someone's beneficiary is living.

So, what is an annuity? Essentially, your parents agree to pay a certain amount of money to an insurance company, either in a lump sum or several payments. After a period of time, the company agrees to make a series of payments back to your parents. The earnings on the annuity are not taxed until your parents receive their distributions.

The basic function of an annuity policy is to liquidate a sum of money systematically over a period of time.

Annuity contracts offer a tremendous range of options. Your parents can buy an annuity with a single payment or a series of periodic payments. They can schedule benefits to begin immediately or be deferred until a specific future date. They can choose an annuity that pays benefits for a specific period of time -- or for the lifetime of one or two individuals. It can begin paying those benefits on a specific date (such as when they reach a stated age) or a contingent date (such as when one parent dies).

An annuity that pays benefits immediately typically will provide a steady stream of retirement income in return for the purchase. An annuity that pays benefits at a later date (a deferred annuity) typically will help accumulate money.

Usually, but not always, an annuity guarantees a lifetime income for the recipient.

The annuitant is the insured, the person on whose life the annuity policy has been issued. As with life insurance, the owner of the contract may or may not be the annuitant. Unlike insurance, though, the annuitant is the intended recipient of the annuity payments.

Depending on the type of annuity and the method of benefit payment selected, a beneficiary also may be named in an annuity contract. In these cases, annuity payments may continue after the death of the annuitant, for the lifetime of the beneficiary or for a specified number of years. So, if your dad dies, your mom (as a named beneficiary) can keep getting the payments for the rest of her life.

Beyond these basic terms, it's hard to generalize about annuities because there are so many varieties, each tailored to fit an investor's specific needs. But they are useful tools to avoid outliving one's money...and could become important to your parents' financial health if they live a long time.

(In Chapter 8, we'll delve deeper into how you can use annuities to achieve specific financial goals. In this chapter, we'll focus more on the mechanics of how they work.)

You'll want to have a general understanding of what annuities can do for your parents over the course of their later years...before talking with the sellers of these policies. There's a lot of promotional material out there about annuities -- and lots of salesmen, agents and "financial planners" ready to sell your parents with a good pitch.

Most investors think of annuities as souped-up certificates of deposit (CDs) or mutual funds that allow your money to compound free of taxes. And that's how one version -- deferred annuities -- works. But annuities were originally intended not as accumulation vehicles but as a way to convert assets into a steady income, a process known as "annuitizing" or "annuitization."

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