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An annuity is a type of investment account that can provide supplemental income upon retirement. Like other types of investment accounts, annuities have their benefits and drawbacks. Learn more about how annuities work, their main pros and cons, which types to consider, and who can benefit the most from an annuity.
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How annuities work
Annuities are types of contracts between the investor and the insurance company. You can start an annuity with a lump sum of cash and then add contributions as you like. Depending on the type of annuity you choose, you can expect fixed or variable returns on your investment. Here are some details on the three types of annuities.
- Fixed annuities: This type of annuity offers a fixed return, which can be helpful for budgeting during retirement, but can limit the returns on your money.
- Variable annuities: This type of annuity invests your money in stocks and bonds, which could result in higher overall returns over time—but this also means your money is vulnerable to market fluctuations and could have a lower return than expected.
- Indexed annuities: This type of annuity invests your money in a stock market index, such as the S&P 500 or the Dow Jones. This can be a less volatile strategy than investing your money in stocks and bonds, but still isn’t as safe as a fixed annuity.
Benefits of annuities
Annuities have many benefits. They can help you live more comfortably and predictably during retirement. They also are a great option for high-income individuals who may max out their contribution limits on other types of retirement accounts.
Guaranteed income
Annuities provide income when you retire. This money can be used to supplement your retirement income from sources such as Social Security, a 401(k), or an IRA. Having guaranteed income from an annuity can help you be more financially stable upon retirement, allowing you to enjoy those years rather than spending them worrying about money.
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Fixed returns
Fixed annuities offer a fixed return that allows you to calculate exactly how much money you’ll have upon retirement. This can help you budget more easily and live more comfortably during retirement.
No contribution limits
Unlike 401(k) plans or IRAs, which have IRS-imposed annual contribution limits, annuities don’t limit how much money you can contribute. This makes them ideal for high-income individuals who may want to save more for retirement than their other plans permit. With an annuity, you can save as much or as little as you want (within reason, as many annuities have a minimum contribution required to open).
Disadvantages of annuities
Annuities usually come with annual fees, and withdrawing money before retirement can result in a hefty penalty. The money in an annuity is also inaccessible during the contract period, which can be a disadvantage if you’re facing an unexpected expense. What’s more, depending on the type of annuity you select, you may end up giving the insurance company more than you—or your heirs—receive in payments.
Fees
Many annuities impose annual fees reimbursing the issuer for investing and managing the money on your behalf. The fees can be around 2% or 3% per year—higher than for many other types of investments. Additionally, annuities are subject to a 10% penalty tax if you withdraw funds before age 59½; this penalty is imposed by the IRS and is similar to the penalties for 401(k) early withdrawal. However, there are usually fewer exceptions for early withdrawal from an annuity than from a 401(k).
Inaccessible funds
Once you’ve contributed funds to an annuity, they’re not accessible until you reach age 59½. For some investors, this isn’t an issue—but if you’re faced with a large and unexpected expense, you may find that you suddenly need that money, which means you’ll be subject to the 10% penalty. That’s why it’s a good idea to have an emergency savings fund in place, as well as other investment options that allow you to access funds as needed.
Potentially variable returns
A fixed annuity has a guaranteed rate of return, but variable and indexed annuities have more variable returns. That’s because the contributions to these types of annuities are invested in stocks, bonds, or mutual funds, which are vulnerable to market fluctuations. If the market experiences losses, so too will the annuity. However, on the flip side, market gains will result in a higher rate of return for a variable or indexed annuity, while a fixed annuity won’t be affected either way.
May leave no inheritance for heirs
With some kinds of annuities, you take a gamble: If you live a long time, you may receive more than you paid in. If you die younger, you could receive less than you paid in, with possibly nothing left for your beneficiaries. However, as Northwestern Mutual points out, there are four ways to structure annuities that can result in different payouts, and some forms do leave money for beneficiaries. The annuity structure you choose affects how large your monthly payment will be, with some versions providing higher amounts than others.
- Life-only annuity. Payments stop when you die—or, in joint-life, when a second person dies. Any balance stays with the insurance company.
- Life with refund. Payments are for life. But if you die before the amount you paid in has been spent, your beneficiary gets the balance.
- Life with period certain. Payments are for life (or joint life). But you select a certain period (say 10 or 20 years), and if you die before then, your beneficiary gets the payments through the end of the period.
- Period certain only. Payments continue for a specified period of time. If you die before the period ends, your beneficiary gets the rest of the payments. If you live beyond the specified period, the payments end.
Who can benefit from annuities?
Despite their many benefits, annuities aren’t for everyone. However, some investors will find them very useful in building wealth that they can use during retirement. The following are some scenarios where you may benefit from an annuity.
- High-earners. If your salary is on the high end and you’re already maxing out your contributions to your other retirement savings accounts, an annuity provides an additional option to help you save even more for retirement.
- Retirees. If you’ve already retired and want a way to supplement your retirement income, an annuity could be a good option. If you opt for an immediate annuity, you’ll start receiving payments right away, which can help you cover your regular living expenses when you’re not working and can replace your regular paycheck.
TIME Stamp: Annuities can supplement retirement income, but they can also be volatile and tie up your money.
An annuity is a solid option to add to your retirement income, but that doesn’t mean it’s the best choice for everyone. Weigh the pros and cons of an annuity before deciding to take this route for your retirement. A financial advisor can help decide if an annuity is a good choice for you.
Frequently asked questions (FAQs)
Why are annuities a poor investment choice?
Annuities can be a bad choice for some people—they have higher fees and less flexibility than some savings options. And depending on the type you choose, your heirs may get nothing after you die even if far less was paid out than you had contributed. but for others they are a great option to help save for retirement. However, it’s inadvisable to use an annuity as your only source of retirement income. Rather, annuities can be a good option for retirement contributions once you’ve maxed out your allowable contributions for a 401(k) or IRA.
What is better than an annuity for retirement?
Annuities are good options for some people—especially those with high incomes—but for others, an employee-sponsored retirement plan such as a 401(k) is usually the best option. You can also open an individual retirement account, or IRA, to save even more money for your golden years. If you make enough money that you can max out your contributions to other types of retirement accounts, then an annuity is a good option to continue saving for retirement.
What is annuity income?
Annuity income is the money you receive once you opt into annuity disbursements after age 59 ½. You can use that income to supplement your other retirement income, such as Social Security, your 401(k), and an IRA. This can help ensure you have enough money to live on once you’re ready to stop working.
Are annuities taxable?
Yes, annuities are taxable—but only when the funds are withdrawn at retirement. When you start receiving disbursements, the money will be taxed using your pre-retirement income tax bracket. However, if your annuity contributions are post-tax, your withdrawals will be tax-free. However, your returns will still be taxable.
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