You have come across the term “annuity” during retirement planning with your financial advisor, or in discussing your retirement options with your friends and family. Read on to find out what an annuity is, the pros and cons, and how to decide whether purchasing an annuity is right for you.
What is an Annuity?
An annuity is a financial product that investors use to either save for retirement, tax-deferred, or to generate regular income to replace a paycheck in retirement. You can fund an annuity over time or in one lump sum.
In general, annuities cost much more to administer than an IRAs or 401(k). And, those costs and fees vary widely among issuing companies. If you purchase an annuity through an agent rather than direct from the insurer, you will have to pay the agent a commission as well. Shop around.
There are two main types of annuities: variable annuities and income annuities.
In general, variable annuities are similar to a conventional IRA in that they help you build savings for your retirement, and the earnings are tax-deferred until withdrawn. The strategy is to invest and grow that investment tax-free and then make withdrawals after you retire when, presumably, you will be earning less, be in a lower tax bracket, and pay less in taxes on the withdrawals.
You can purchase a portfolio at any level of investment risk you are comfortable with – just remember, the higher the risk, the higher the reward if the portfolio performs well, but the greater the losses if it does not.
Advantages of Variable Annuities
It is possible to pass the balance of a variable annuity to your beneficiaries. Your beneficiaries will receive the death benefit directly, which avoids the delay and cost of probate court.
Tax advantages of variable annuities go far beyond tax deferment. There is no tax limit to contributions, and, there is no tax requirement that you start withdrawals once you turn 70 ½ if you contributed after-tax funds to the annuity.
Disadvantages of Variable Annuities
Some disadvantages to variable annuities are:
- Higher costs and fees than IRAs and 401(k) plans because annuities are insurance contracts
- Some charge withdrawal penalties called “surrender charges”
- Are more appropriate for long-term saving as it takes time for the tax deferral benefit to outweigh the higher costs and fees
- Are subject to market gains and losses
Also called a “fixed annuity,” an income annuity provides guaranteed income in retirement. Essentially, you buy guaranteed future income with a portion of your retirement assets. The income can last for a fixed period of time, or your lifetime, or your lifetime plus another person’s lifetime. The amount of income and when that income begins to distribute is your choice.
There are two different types of income annuities. Immediate Income Annuities provide regular income beginning between 30 days and 1 year of purchase. Deferred Income Annuities are what they sound like – regular income payments are deferred until at least 1 year after purchase.
Advantages of Income Annuities
- Establishes stable monthly cash flow in retirement
- Monthly payments for your lifetime guaranteed – no risk of outliving your income
- Supplements your Social Security payments in a predictable amount
- Accrues interest in a fixed amount
Disadvantages of Income Annuities
You have no access to the funds in the annuity other than your monthly income payments. You must keep an emergency fund at hand just in case. Also, while an income annuity provides stable income while the corpus grows at a fixed interest rate, it can not accumulate the type additional savings a variable annuity can given the right market conditions.
Still wondering about an annuity?
- You cannot outlive your income
- Contributions are tax-deferred
- Payout – guaranteed amount in an Income/Fixed Annuity, varies with market conditions in a Variable Annuity
- Costs to administer are high, and perhaps you have to pay a commission to an agent
- A hefty surrender fee applies if you need to make an unscheduled withdrawal
- This is a new, complex financial product – read everything before signing, and do not sign anything you don’t understand.
- While the contributions are tax-deferred, the income stream is taxed as regular income – higher than the long term capital gains rate.
- If you die before your original investment has been paid out, your heirs get nothing unless you pay extra (qualified joint and survivor annuity).
- Most annuities do not adjust for inflation, so you receive the same amount of income at 80 than you did at 70 – the world changes a lot in 10 years, but your income won’t. If the annuity offers indexing to inflation you can purchase that, but be forewarned that an inflation protection rider is expensive.
How to Decide Whether You Should Purchase an Annuity
Conventional wisdom dictates that investors should max out the other available tax-advantaged retirement products, such as IRAs and 401(k)s, prior to considering purchasing an annuity. Any additional money set aside for retirement might then be used to purchase an annuity – especially if you are in a high tax bracket right now.
If you are shopping for an annuity, you would be wise to consider purchasing from only the well-known, older firms with an established reputation for being trustworthy. In other words, if the terms of an annuity from Acme Annuity Co. sound too good to be true, chances are they are.
There are many complex variations on the types of annuities outlined in this article. No matter what type of annuity you are interested in, under no circumstances should you sign anything you do not understand.
Veronica Baxter is a freelance writer and legal assistant operating out of the greater Philadelphia area. She works frequently with Chad Boonswang, Esq., a busy Philadelphia life insurance attorney.
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