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You're likely aware that saving for retirement is crucial. If you envision a future where you're free to enjoy life without depending on a job, you'll want to invest in an IRA, take full advantage of an employer 401(k) match, or ideally, do both. But have you considered adding annuities to your retirement strategy? Here’s a basic overview of what annuities are all about.
Understanding How Annuities Function
An annuity is like a combination of insurance and an investment account. When you dive deeper, it leans more toward the insurance side, and it can be somewhat complicated. In simple terms, an annuity is a financial product that guarantees income once you retire. You pay a premium (or a lump sum) upfront, and when you reach age 59 ½, you’ll begin receiving guaranteed payouts. Sounds promising, right? Well, perhaps…
Beyond the basic explanation, there are some essential facts about annuities you should grasp. Understanding these points will give you a clearer picture of how they function, along with their advantages and drawbacks. Keep these fundamental aspects in mind:
Tax-Deferred Advantage: Annuities offer a tax benefit. The key advantage? Your earnings (but not contributions) are tax-deferred. This means that the money you earn in the annuity isn't taxed until you withdraw it in retirement, similar to how a traditional IRA or 401(k) works.
Save More Money: Both 401(k)s and IRAs have contribution limits each year, set by the IRS. However, there is no IRS cap on how much you can put into an annuity. Unfortunately, you typically cannot deduct your contributions to an annuity from your income the same way you can with a Traditional IRA or 401(k). Unless you're purchasing the annuity through your IRA or 401(k), it's paid with post-tax dollars. We'll explain how this works later.
Guaranteed Retirement Income: One of the biggest selling points of annuities is that they provide a guaranteed income in retirement. Once you purchase the annuity, the insurance company commits to paying you a certain amount over a defined period. If you withdraw the funds before reaching retirement age (59 ½), you'll incur a 10% penalty on the taxable portion of the annuity.
It’s a Pool of Funds: Like other insurance products, annuities are funded through premiums paid by others. When people in the pool pass away, their contributions are used to fund the annuities of other participants.
These are the fundamental aspects, but there are multiple types of annuities, each with unique features.
Exploring the Various Types of Annuities
Annuities can be categorized in various ways, based on factors like payout, growth, and how you contribute. The two most fundamental categories are deferred and immediate annuities.
Deferred vs. Immediate Annuities
With a deferred annuity, you contribute money to the annuity over a period of time until you're ready to begin withdrawals. On the other hand, with an immediate annuity, you make a lump sum investment upfront, and the annuity starts paying out right away or within a year. This type is typically considered if you're approaching retirement and haven't saved enough.
In essence, the deferred annuity grows over time, while the immediate annuity provides payouts...immediately. As noted by Learnbonds, deferred annuities typically have waiting periods of 5 to 10 years, after which you have several options:
Withdraw your funds. This will result in immediate tax consequences.
Transfer your funds into a new annuity, tax-free.
Convert your deferred annuity into an immediate annuity, a process known as 'annuitization'.
The primary advantage of a deferred annuity is the ability to postpone taxes. While both types of annuities offer tax deferral, this benefit truly shines over time. If you're withdrawing the funds immediately, there's no growth to defer taxes on. However, if you're nearing retirement, the immediate annuity provides clear benefits.
Fixed, Variable, and Indexed Annuities
Annuities can also be categorized based on how they grow.
A fixed annuity provides a set interest rate and guarantees a certain payout based on your balance. It's a low-risk option, but the return tends to be modest. It’s similar to a CD, with rates typically just slightly higher than those of a CD.
If you're looking for a higher return, you might consider a variable annuity. In this case, your funds are essentially invested in mutual funds, offering a higher rate of return but with increased risk. As a result, your retirement payout will depend on the performance of those investments. Additionally, variable annuities generally come with higher fees.
Finally, there are indexed annuities, which aim to combine the best features of both types. They guarantee a minimum payout, but you can also benefit when an index (like the S&P 500) performs well. While this sounds appealing, it can be too good to be true. CNN reports that these annuities can be overly complex, misleading, and often come with restrictions that prevent you from fully capitalizing on an index's performance.
Payout Options
Different annuities offer various payout structures. You can opt for periodic payments throughout your life, receive a lump sum when you retire, or choose payments over a specific number of years.
Some annuities, such as Lifetime Annuities, do not provide benefits to beneficiaries. This means that after your passing, the remaining funds are forfeited. Other annuities come with a guaranteed death benefit, where a designated beneficiary receives a specified sum after your death. CNN outlines several basic types of annuity payout options:
Income for a guaranteed period, also known as a period certain annuity: This option guarantees a set amount for a predetermined period. If you pass away before the period ends, your beneficiary will receive the remaining payments.
Lifetime payments: This provides a guaranteed income for your lifetime. Once you pass away, payments cease.
Income for life with a guaranteed period certain benefit: Also referred to as “life with period certain,” this option ensures a guaranteed payout for your life, with a period certain phase. If you die during this phase, your beneficiary will receive the remainder of the payments for that period.
Joint and survivor annuity: This is typically an option for married couples, ensuring that the beneficiary continues receiving payouts for the remainder of their life.
If you're considering an annuity, you'll need to decide when you'd like to start receiving payments (immediate or deferred), how you want your money to grow (fixed, variable, or indexed), and the type of payout options you'd prefer. Naturally, the more attractive the annuity, the higher the cost.
Why People Like Annuities
There are two primary reasons people turn to annuities. First, they appeal to those looking to make up for lost time in saving for retirement. If you're behind and worried about your financial future, an annuity can provide a steady and predictable income. However, it's important not to rely solely on annuities for your entire retirement plan. Diversification is key—especially when that annuity comes with a hefty price tag (but we'll discuss the fees shortly).
It's also unwise to treat an annuity as an investment—it's an insurance product. While it’s possible to earn some returns, annuities are primarily designed to provide financial security, not to help you grow your savings. Considering the fees attached to annuities, there are often more cost-effective ways to invest your money.
Another draw of annuities is the tax benefits they provide. If you've maxed out your 401(k) and IRA, congratulations! Now, you might be looking for another way to grow your wealth. While taxable investment accounts are an option, they don't offer the same tax advantages as annuities. Yes, you’ll eventually pay taxes on your earnings, but not until you withdraw the funds.
Why People Don’t Like Annuities
Many annuities come with hefty fees, making them far from ideal as an investment choice. In fact, they’ve gained a reputation for being quite expensive. Here’s a rundown of some of the costs associated with an annuity:
Commissions: According to Forbes writer (and former annuity salesman) Tim Maurer, some annuity commissions can reach as high as 15%, while CNN estimates them to be around 10%. As expected, the cost of these commissions is included in the price of the annuity.
Surrender charges: If you decide to withdraw funds from your annuity within the first few years of purchase, you’ll be subject to a surrender charge. The Motley Fool reports that a typical surrender charge in the first year is about 7% of your account value, which decreases by 1% each year until it’s gone.
Annual fees: Variable annuities tend to have higher ongoing costs. CNN suggests that these fees may reach as high as 1.25% for an annual insurance charge, plus an additional 0.5 to 2% for management fees.
Moreover, many annuities offer returns that are simply too low. As Maurer highlights over at CNBC, the rates can be so dismal that they might be outpaced by inflation. So, if you’re thinking about getting an annuity, he recommends waiting until the rates improve. But again, remember that an annuity is an insurance product, not a true investment.
Lastly, while annuities are tax-deferred, their tax burden can be surprisingly high. Normally, capital gains from investments are taxed at a lower rate than regular income, but this doesn’t apply to the capital gains from an annuity. These gains are taxed as ordinary income. The tax rules can be complex, but the Motley Fool explains them in more detail here. The takeaway is that the tax-deferred benefit of an annuity becomes less attractive once you begin withdrawing funds.
Should You Have an Annuity?
Most financial experts generally advise against considering annuities unless you’re approaching retirement age, trying to catch up on savings, and require a guaranteed income stream.
Before contemplating an annuity, make sure you’ve maxed out contributions to your 401(k) and IRA. These accounts provide the same tax-deferral benefits without the hefty fees. Moreover, if you're investing in an annuity through your 401(k) or another tax-advantaged account, you won't receive any additional tax benefits since the funds are already in an advantaged account.
If you’re set on pursuing an annuity, there are several ways to go about it. Some 401(k) or IRA plans allow you to invest in an annuity, but U.S. News highlights that you may not be able to transfer that money into a new 401(k) plan if you switch employers.
However, if you change jobs, you can transfer your existing 401(k) into an annuity. U.S. News reports:
If you leave your job for any reason—whether it's a new opportunity, being laid off, fired, or simply quitting—it counts as a separation from service. Under these conditions, you may roll over a portion of your vested balance into an annuity. Additionally, upon retirement, you have the option to roll over part of your balance into an annuity, and your plan may even offer discounts for doing so.
Alternatively, you can choose to buy an annuity independently, outside of your employer's 401(k) plan. Investment firms like Fidelity and Vanguard provide various annuity options, as do some insurance companies.
Before proceeding, it's crucial to carefully evaluate the fees, the company's credit rating, and other important factors, such as surrender charges and payout options. While annuities aren’t suitable for everyone, they can be worth considering if you're worried about your retirement income. As with any financial decision, always read the fine print, do thorough research, and fully understand what you're committing to.
