Read This Before Purchasing an Annuity
From 401(k) plans to IRAs, there is seemingly no shortage of ways to save for retirement. One popular vehicle to do so? An annuity.
Deciding to invest in annuities isn’t always so clear-cut, as this option is often complicated and confusing. This post aims to arm you with knowledge so you can best evaluate these products should the opportunity to purchase one ever arise.
What’s an annuity, and how does it work?
An annuity is a type of insurance product that gives investors a guaranteed stream of income whereby you pay money up front (via a lump sum or series of payments), which is then invested and later paid out per an agreed-upon time, amount, and timeframe.
All annuities have two components: the principal you pay into it and your returns on the same. Depending on the type of annuity you move forward with, you can use either pre-tax (qualified annuities) or post-tax (non-qualified annuities) dollars to fund it. Regardless of which option you choose, annuity account investments can grow tax-free.
Annuities aren’t insured by the FDIC or any federal government agency. Instead, state guaranty associations (nonprofit organizations regulated at the state level) provide a safety net to protect policyholders. Coverage amounts vary by state but generally rise to $250,000.
Annuity types: immediate and deferred
Two basic annuity categories exist: immediate and deferred. While the former provides a guaranteed income stream (often within a year) for the exchange of a lump sum today, the latter allows you to contribute a series of payments (or a lump sum) and begin collecting income at a set point in the future. Investments grow tax-free, with payments typically continuing to grow as you delay collecting.
Either option tasks you with deciding whether to receive payments for life or during a set period of time only. Moreover, as with many other retirement vehicles, any funds cashed out before age 59½ are subject to a 10% IRS penalty.
Immediate and deferred annuity options: fixed, variable, or indexed
Fixed, variable, and indexed annuities are available within the aforementioned categories, as follows…
Fixed annuities are generally straightforward, with your contract outlining the amount and timing of your future payments. Though you likely won’t have any control over how the money is invested, this in fact doesn’t matter as the rate of return is predetermined and guaranteed (akin to a CD).
The drawback of fixed annuities is that inflation may erode the value of payouts, which is sometimes risky for those relying on an annuity to pay the bills in retirement.
The objective of variable annuities, meanwhile, is to combat inflation risk with market exposure and provide higher returns. Money in these accounts is therefore often invested in various stocks, bonds, and mutual funds (“subaccounts”), making variable annuities inherently riskier than their fixed counterpart as the account balance and future payouts can vary based on financial market performance. Moreover, unlike fixed annuities, variable annuities are not entirely guaranteed.
These features explain why variable annuities are considered securities rather than insurance products; likewise, a broker or financial advisor who sells you a variable annuity must be registered with the U.S. Securities and Exchange Commission.
It’s important to note that variable annuities offer optional—but sometimes costly—add-on features (“riders”) to help minimize some of your risk.
For example, floor caps can minimize losses should your underlying investments take a nosedive, while the guaranteed minimum accumulation benefit (GMAB) can guarantee your account value will equal a fixed percentage of your premiums.
Also known as “equity-indexed” or “fixed index” annuities, indexed annuities represent a hybrid of fixed and variable options and credit interest back to you based on two factors: your minimum guaranteed rate and additional returns tied to the performance of a market index (such as the S&P 500 or Dow Jones Industrial Average). As a result, returns typically fall somewhere between those of fixed and variable options.
It’s important to consider participation rates—the percentage of an index’s return credited to you—when assessing indexed annuities. For example, a participation rate of 70% would cause index-linked returns to only amount to 70% of gains associated with the index; if your annuity is tied to the S&P 500 and that index gains 10%, in this case, your annuity would be credited with only 7% of the gain.
Reasons to consider buying an annuity
As the goal of an annuity is to provide a steady stream of income—typically during retirement—these are often appropriate investments if you’re:
· A conservative investor seeking a guaranteed source of income for the rest of your life
· Worried about running out of money during retirement
· Wanting to protect your legacy (if your policy includes a death rider, you can pass your annuity to one or more named beneficiaries)
Looking to continue funding your retirement after already maxing out all other vehicles (such as a 401(k) or IRA)
Reasons to avoid buying an annuity
Annuities aren’t for everyone, and there are in fact many disadvantages to owning one.
For starters, they’re often complex (some needlessly) and include a wealth of perplexing features. They’re also expensive and can feature a variety of fees that make this type of investment even less attractive (e.g., with a “surrender period,” the window of time you must keep funds in the annuity to avoid paying fees, you’ll get hit with charges if you need to access the money sooner than anticipated).
Another reason to steer clear of an annuity is that the investment may not provide the level of returns you can potentially achieve elsewhere. This is a critical consideration, especially if you haven’t yet maxed out other retirement vehicles such as a 401(k) or IRA. It’s also possible to lose more than just your returns depending on the type of annuity you decide to purchase.
Finally, if the insurance company you purchased your annuity through goes bankrupt, this can adversely impact your payouts as state guaranty association coverage is limited; it’s thus important to select a reputable insurance company with a solid track record of financial strength.
The bottom line on how annuities work and if they’re right for you
Choosing to invest in an annuity is by no means an easy decision, and it’s important to understand the precise product you’re buying. In addition to reading the fine print, consult a financial advisor who can help you understand if (and how!) annuities fit into your overall retirement plan.
Questions about annuities and if they are right for you? Schedule a FREE Discovery call with one of our CFP® professionals.
FAQs
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Monthly payouts depend on several factors, including the type of annuity, riders, age/gender, and the start and duration of payments. That said, per Annuity.org, a 65-year-old female who purchases a deferred income annuity that starts paying out at age 70 can expect to receive somewhere around $820 per month for life.
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It depends! While annuities are often a solid investment (e.g., for those seeking a guaranteed stream of income during retirement), the reverse also holds true as investors can fall victim to high fees or a failure to understand what they signed up for—a looming problem, as annuities are often complicated investments.
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If you own a qualified annuity (funded with pre-tax dollars), you’ll pay taxes at the time of withdrawal (or payout) on the full withdrawal amount. If you set up a non-qualified annuity (funded with after-tax dollars), meanwhile, you’ll only pay partial tax based on the “exclusion ratio”: the portion of your investment’s return that isn’t taxed, taking life expectancy into account.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59 1⁄2 are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value. Riders are additional guarantee options that are available to an annuity or life insurance contract holder. While some riders are part of an existing contract, many others may carry additional fees, charges and restrictions, and the policy holder should review their contract carefully before purchasing. All guarantees are based on the claims paying ability of the issuing insurance company.
