What Is an Annuity?
An annuity is a contract with an insurance company that guarantees current or future payments in exchange for a premium or series of premiums. The interest earned on an annuity contract is not taxable until the funds are paid out or withdrawn.
Withdrawals and income payments are taxed as ordinary income. If a withdrawal is made prior to age 59½ from a qualified annuity, penalties may apply. The guarantees of an annuity contract depend on the issuing company’s claims-paying ability. Annuities have fees and charges associated with the contract, and a surrender charge also may apply if the contract owner elects to give up the annuity before certain time-period conditions are satisfied.
Although annuities can protect you from some types of financial risk, annuities often come with upfront fees and higher costs that wouldn’t be associated with other investment types that may provide you with higher potential returns. These fees can also cause you to lose any earnings that could have been potentially kept if investing traditionally. Another criticism is that they are illiquid and funds used to purchase an annuity are often locked up for a certain period of time.
How Does an Annuity Work?
An annuity is a long-term investment designed to help you grow your retirement income. There are different types of annuities:
Immediate annuities are designed to provide an immediate guaranteed lifetime payout by trading liquidity for guaranteed income. If you need your liquid income during an emergency or another event, you won’t have access to it. Fees are woven into the payout so when you contribute a certain amount of money, you know exactly how much your payouts will be for the rest of your life.
Deferred annuities provide guaranteed income in the form of a lump sum or monthly payments on a date in the future. You pay a lump sum, or monthly premiums to an insurance company, who invests them into the growth type you agreed to. Types of deferred annuities include Fixed, Variable and Index.
Deferred means you won’t have to pay taxes on this income until you take the money out. There is also no limit on the amount you can contribute, unlike a Roth IRA or 401(k).
Fixed annuities are the simplest annuity to understand. An insurance company gives you a guaranteed fixed interest rate on your investments when you agree to a length of your guarantee period. These are not based on market volatility so you know exactly how much your monthly payments will be. Because the interest rate is fixed these types of annuities don’t benefit from the potential growth of the market.
Variable annuities are tax deferred annuities where you invest your money into sub-accounts while guaranteeing lifetime income. This type of annuity has the potential for larger future payments if the underlying funds perform well or lower payments if the funds perform poorly. This could result in less stable cash flow than a fixed annuity, but allows for the annuitant to participate in the upside of strong returns from the underlying funds. For an extra cost you may be able to add riders to the contract that provide for a guaranteed lifetime minimum withdrawal amount, death benefit or cost of living adjustment. These are a great option if you’ve already maxed out your Roth IRA and 401(k) and want to save additional funds in a tax-deferred manner.
Using an annuity calculator can help with:
- Forecasting the growth of an annuity with optional annual or monthly additions
- Finding the payment amount that would deplete the fund in a given number of years
- The amount needed to generate a specific payment
- The number of years your investment will generate payments at a specific return
Disadvantages of Annuities
Although annuities can protect you from some types of financial risk, annuities often come with upfront fees and higher costs that wouldn’t be associated with other investment types that may provide you with higher potential returns. These fees can also cause you to lose any earnings that could have been potentially kept if investing traditionally. Another criticism is that they are illiquid and funds used to purchase an annuity are often locked up for a certain period of time. This is known as the ‘surrender period’ during which the annuitant would incur a penalty if they were to withdraw all or a portion of the funds. These periods can last anywhere from two to more than ten years depending on the product and can start at 10% or more and decline annually throughout the surrender period. You must choose an annuity carefully as each annuity can be beneficial or detrimental depending on your personal financial situation and goals.
With so many different types of annuities and risks associated with each, it’s best to calculate your retirement with a financial advisor.