The equity-indexed annuity (EIA) has been around since 1995, and in its short life has proven to be a fast-growing alternative to fixed-rate annuities and certificates of deposits. And with good reason. Since their inception, these annuities have outperformed both bond indexes and the S&P 500 overall.

Here is how they work. EIAs provide a guaranteed interest rate along with the ability to earn a percentage of certain market-driven indexes, mimicking characteristics of both fixed-rate and variable annuities. The percentage of the index's gain that a customer receives varies, with some companies offering 50% and others offering 100% or even more. Because of this wide variance, it is critical that you read the fine print. It is important to note that every equity-indexed annuity is different, and there are several questions you should ask your agent or broker before deciding to invest. Some of the best questions to ask are:

What is the term on the annuity?

With an equity-indexed annuity, your money will be tied up from a required five to 10 years. Similar to any other stock investment, the shorter the term, the greater the risk the stock market won't perform well over the holding period.

What will you earn when the market goes up?

Equity-indexed annuities credit you anywhere from 50% to 100% of the price gain of the market, excluding dividends. Since you are not earning dividends, you won't earn as much as you might by investing directly in the market. The percentage rate you earn can vary from year to year, so make sure you check with your agent on the details.

At the end of the term, how does the company calculate your earnings?

It depends on the individual annuity. Some equity-indexed annuities use the market price on the day your annuity matures. Others measure the market price on each anniversary and pick the highest one. Some policies average the gains, while others credit you with a portion of each year's market gains. To make the best decision, make sure you understand which method the policy you're considering uses.

Are there any earnings caps?

Equity-indexed annuities often put a cap on yearly earnings, and some policies allow the insurer to change the cap annually. Ask your agent for further details on this topic.

What happens if the market trends down?

If the market drops one year, you will be credited with no gain that year. The crediting method the company uses will drive what happens in subsequent years, especially if the market doesn't return to previous levels.

What are the repercussions of cashing in the annuity early?

Some policies will give you the guaranteed minimum return, while others will credit you with all or part of your earnings, minus the surrender fee.

What if the market crashes?

Equity-indexed annuities carry a minimum return, but only if you keep the contract until its maturity date. The guaranteed return is usually 3%, but might not be 3% of your original contribution. Some companies guarantee you will get at least 3% of 90% of what you spent. Also, make certain you understand how that minimum return is computed.

Liquidated earnings are subject to ordinary income tax, may be subject to surrender charges and, if taken prior to age 59 1/2, may be subject to a 10% federal income tax penalty. Guarantees and payment of lifetime income are contingent on the claims paying ability of the issuing insurance company.

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