Takeaways
- Annuities can provide a reliable income stream for retirement planning.
- Annuities are divided into two main types: immediate annuities and deferred annuities.
- Annuities have a variety of structures that give investors flexibility to fulfill their financial needs.
- Annuities have tax-deferred growth, guaranteed income, and customizable options.
- Annuities can have disadvantages such as high fees, surrender charges, and inflation risk.
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The financial market consists of many financial products. One of the lesser-known and helpful products is an annuity. Annuities help with retirement income planning. As part of your financial planning, many financial advisors advocate exploring annuities for securing a steady income stream during retirement. An annuity can remove financial anxiety and give you the comfort of certainty. This feeling can be priceless, so let’s explore the full definition of an annuity.
What is an Annuity?
An annuity is a contractual arrangement between an individual and an insurance company. This structured agreement is designed to help provide you with a reliable income stream at predetermined future dates. An annuity can help you in a variety of ways. It can help by giving you a guaranteed income during your retirement years, bolstering your retirement portfolio diversification, and extending your current portfolio.
Depending on how your retirement planning is progressing, investing in an annuity could be the appropriate financial planning decision. However, a comprehensive understanding of annuities is essential for making informed decisions regarding your financial security.
How an Annuity Works
Annuities can be customizable to fit your retirement needs. While this customization is advantageous, it can make annuities more complicated than buying stocks or bonds.
The life cycle of an annuity consists of two main phases:
- Accumulation Phase: This is the period of an annuity where you fund the annuity before any payouts commence. The funds you invest can grow on a tax-deferred basis during the accumulation phase.
- Annuitization Phase: Once the accumulation phase ends, the annuitization phase begins. The annuitization phase is when you start receiving payments from your annuity.
Once the annuitization phase begins, you can monitor your annuity investment to ensure your insurance provider keeps with the original annuity terms. This monitoring should be conducted annually.
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5 Types of Annuities
If you are exploring investing in an annuity, you can work with an insurance provider to structure your annuity to fit your unique financial situation. Consult a financial advisor to see how your savings align with your long-term financial goals. Here are five types of annuities to consider during the planning process:
1. Immediate Annuities
An immediate annuity is created with a lump sum payment. Investors nearing retirement like this solution because it is not complicated and has low fees. To start an immediate annuity, you write a check to an insurance provider and begin receiving guaranteed monthly payments. With an immediate annuity, you convert a single lump sum into a series of payments over time.
You can make this lump-sum payment from your slush fund, savings, or investments or some portion of your 401(k) savings. Guaranteed monthly payments will vary based on your plan, the size of your upfront payment, age, sex, and annuity terms.
2. Deferred Annuities
A deferred annuity starts paying out at a specific time in the future. This can be great for annuitants because your investments can accumulate, allowing you to receive higher payouts later.
3. Fixed Annuities
Fixed annuities are financial products sold by insurance companies that allow you to trade your cash in exchange for principal payment plus a fixed interest rate. Fixed annuities guarantee a set interest rate for a predetermined period, which offers stability and predictability.
Because fixed annuities can be flexible in their structure, you could construct your payment to be:
- Fixed monthly dollar payments (e.g., $3,000)
- Fixed interest payments (e.g., 8%)
- Combination of a set dollar amount plus interest
4. Variable Annuities
Variable annuities allow you to make one lump-sum payment or a series of payments in exchange for a future single payment or series of payments. The difference between variable and other annuities is that your initial payments are invested. Some variable annuities invest in subcategories (like mutual funds), which invest in stocks, bonds, or money market accounts. With your capital invested, you have the potential to earn high returns and allow your gains and appreciation to grow unencumbered by taxes.
One critical point to note is that with a variable annuity, you are subject to more market risk. For example, if you invest in a variable annuity where the underlying investments perform well, your returns and future payouts may increase. However, if those investments perform poorly, returns and potential future payouts could decrease.
5. Indexed Annuities
If fixed and variable annuities had a baby, it would be the indexed annuity. Indexed annuities usually have two different elements: a guaranteed fixed rate and potential additional returns based on the performance of a predefined market index, like the S&P 500 or Dow Jones.
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Indexed annuities provide you with the opportunity for market-linked growth coupled with downside protection. For instance, if the S&P 500 performs well, your returns could be a combination of a guaranteed fixed rate of return plus the juice from S&P 500 gains. But if the index performs poorly, and does not cross the necessary hurdle rate, you will only receive the fixed component of your annuity.
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Advantages of Annuities
Annuities offer many advantages that make them a compelling option for retirement planning and financial security.
Tax-Deferred Investment Growth: Annuities provide tax-deferred growth, allowing investments to compound without the drag of immediate taxation, thereby accelerating wealth accumulation over time. This tax advantage can benefit individuals in higher tax brackets seeking to optimize their retirement savings. Read more about the 2023-2024 Federal Income Tax Rates and Brackets.
Guaranteed Income: Annuities offer the benefit of a guaranteed income for life, alleviating concerns for investors worried about outliving their retirement savings. With income annuities, retirees know they will receive regular payments regardless of bull market, bear markets, or economic downturns. This feature provides invaluable peace of mind and helps retirees maintain a comfortable standard of living throughout their golden years.
Payment Flexibility: Annuities provide flexible payout options, allowing individuals to tailor their income streams to suit their needs and preferences. Whether opting for fixed payments, variable payments linked to investment performance, or indexed payments tied to market indexes, annuities can be customized to accommodate varying financial goals and risk tolerances.
Diversification: Annuities serve as a valuable diversification tool within a retirement portfolio, mitigating risk by complementing traditional investments such as stocks and bonds. By incorporating annuities, investors can achieve a balanced asset allocation that balances growth potential with income stability, enhancing overall portfolio resilience.
Disadvantages of Annuities
All investments involve risk. Depending on your risk appetite, there are several disadvantages of annuities you should consider:
Fees: One notable disadvantage is high fees, including administrative fees, mortality, and expense charges, and investment management fees. These fees can eat into your investment returns and erode the value proposition of annuities, particularly if you have a low account balance.
Complicated Structure: Additionally, annuities often entail complex contractual terms and conditions that may require more time for investors to comprehend fully. Surrender charges for early withdrawals, minimum guarantee periods, and annuitization requirements are just a few examples of provisions that can complicate annuity contracts and potentially limit flexibility.
Inflation Risk: Annuities may not keep pace with inflation, posing a risk to purchasing power over the long term. Fixed annuities, in particular, offer predetermined returns that may fail to offset rising living costs, leading to a decline in real income over time. This inflation risk underscores the importance of incorporating inflation-hedging strategies into a comprehensive retirement plan. Read about Treasury Inflation-Protected Securities (TIPS).
Liquidity Risk: Annuities are generally illiquid investments that may restrict access to funds, especially during the surrender charge period. Early withdrawals or surrenders may make you incur substantial penalties, reducing the value of your investment and impeding liquidity.
How Annuities Boost Retirement Saving
Despite these caveats, annuities can be instrumental in supplementing and amplifying retirement savings. Annuities provide insulation against market volatility and longevity risk by giving you a guaranteed income stream.
With proper financial planning, annuities can harmonize with your online brokerage account (where you invest in stocks, bonds, and mutual funds) and traditional retirement accounts such as 401(k)s and IRAs, imparting a reliable income source during retirement.
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Annuity income can hedge against essential expenses such as housing, healthcare, and daily living costs, permitting you to savor your golden years without financial trepidation.
How Are Annuities Taxed?
Taxation of annuities varies depending on several factors, including the type of annuity and timing of distributions. Once the annuitization phase begins, you might have to start paying income taxes on your distributions. How you contribute to your annuity determines how your withdrawals are taxed.
Generally, contributions to annuities are made with after-tax dollars, meaning they are not tax-deductible. However, the earnings on these contributions grow tax-deferred until withdrawn.
For example, if you purchase an annuity with pre-tax dollars from a 401(k), you must pay ordinary income taxes on your withdrawals. This is because your contributed pre-tax dollars to purchase this annuity and distributions will thus be taxed.
On the other hand, if you purchase an annuity through a Roth IRA or Roth 401(k), the income you withdraw is tax-free (just like with a regular Roth IRA withdrawal). This is because you contribute post-tax dollars to your Roth IRA or Roth 401(k).
It's important to note that withdrawals made before you are 59 and a half may be subject to a 10% early withdrawal penalty in addition to income tax unless an exception applies [1].
Smart Summary
Annuities can play a critical role in your retirement planning strategy. They can fortify your income in retirement and be tailored to your investment time horizon and risk appetite. The options with annuities can become complicated quickly. Consider working with a financial professional like a financial advisor to help map out your ideal retirement. An annuity could help you get there.
Read More -> Smart Money’s Retirement Planning 101
Frequently Asked Questions
If you are the person who is to receive the payments from an annuity, you are an annuitant. You can also set up an annuity and have someone else be the annuitant (e.g., your spouse).
A surrender fee must be paid if you try to access annuity funds during the surrender period. The surrender period is the time (per annuity contract) when you cannot access your funds. This is why annuities are illiquid investments.
Most investors do not contemplate buying an annuity until they are focused on retirement planning. It might not be worth the investment if you are not worried about outlasting your retirement funds. Not sure where you stand? Read more about the average 401(k) retirement savings by age.
(1) Internal Revenue Service. Topic no. 410, Pensions and annuities. Last Accessed March 19, 2024.
