But not everyone understands how they can fit into a secure retirement, so let’s find out what annuities do and how they work.
What is an annuity?
Annuities are a form of insurance and can only be issued by insurance companies. Whereas life insurance protects against the risk of dying too soon, annuities protect against the risk of living too long. Annuities are one of the few financial products that can guarantee an income you can’t outlive.
There are often two phases of an annuity – the accumulation phase and the income distribution phase, otherwise known as “annuitization.” You can use a lump sum to purchase an annuity or send payments on a regular basis and your contribution earns interest or investment returns. Earnings accumulate tax-deferred, which means taxes aren’t owed until money is withdrawn, which typically occurs at retirement.
At some point in the future, you may elect to turn your accumulated value into an income stream. When you annuitize your contract, you receive a guarantee on the schedule and duration of your income payments. You will likely have options to choose income for life or a set period of time as well as basing it on a single life or two lives (joint).
Types of annuities
An immediate annuity offers the opportunity to generate a guaranteed stream of income, starting within a year after purchase. Think of immediate annuities as “income now.”
Think of a deferred annuity as “income later” where you defer income to sometime in the future. There are three types of deferred annuities.
Fixed deferred annuities offer guaranteed growth at a specific interest rate, making them lower-risk and predictable.
Fixed indexed deferred annuities offer the opportunity to earn interest linked to the changes in performance of an index. Fixed indexed annuities offer protection from market downturns but still allow you to earn higher interest than you would with many fixed interest products.
Variable deferred annuities offer the ability to invest your contributions in variable investment options, making them a good fit for those who want market participation and are prepared to face market risk (and the ups and downs that go along with it).
Considerations when thinking about an annuity
Costs and liquidity are two primary considerations for annuities. Some annuities have a surrender period where you incur a penalty for taking money out or if a withdrawal is made prior to 59.5 federal tax penalties may apply. Once the surrender period is over, your liquidity options increase. Surrender period lengths vary so you want to make sure you understand and are ready to make a long-term decision. You will also want to have a good understanding of all fees related to your annuity as some are more expensive than others.
Why buy an annuity?
There are several good reasons to purchase an annuity.
Perhaps you’ve maxed out your other tax-advantaged retirement plans, such as your 401(k) and IRA. With a nonqualified deferred annuity you can deposit as much money as you want — there is no legal limit (there may be specific product limits).
If you’re close to retirement age, buying an annuity can help you feel a sense of security by providing a guaranteed income during your retirement years.
Annuities aren’t what they used to be. Many of them now offer more liquidity and lower costs. In addition, you can usually purchase optional benefits (for an additional cost) to accommodate specific accumulation, income or legacy needs.
An annuity won’t take care of every financial retirement issue you’ll face, and they’re not a perfect fit for everyone. But they can go a long way toward making the financial side of retirement less challenging.