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Guide to Annuities: Definition, Types, Pros & Cons

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Updated May 17, 2024

An annuity is a type of investment contract between an individual and an insurance company, bank, or brokerage firm. It’s designed to help the investor, or annuitant, save money that they can use as a supplement to their other retirement income, such as Social Security or a 401(k).

This can help guarantee that the annuitant will have enough money to cover their living expenses after they retire and have an income even if they live to be older than expected.

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How does an annuity work?

With an annuity, you’ll contribute a lump sum of cash (or a series of smaller payments) for a certain period of time, after which you can begin making withdrawals. The withdrawals can act as supplemental income to help fund your expenses once you retire. Since annuities are intended for retirement, the IRS imposes a tax penalty of 10% on early withdrawals before age 59 ½.

Although not intended as a sole source of retirement income, an annuity can be an excellent complement to an employer-sponsored or individual retirement account, such as a 401(k) or a Roth IRA. Speaking to a financial advisor at a firm such as J.P. Morgan or Empower can help you determine whether an annuity is a good option to add to your investment portfolio.

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Annuity: Pros & cons

Pros:

  • Annuities are guaranteed sources of income
  • You can add extra benefits in the form of riders
  • Annuity contributions grow tax-deferred

Cons:

  • Annuities come with annual fees ranging from 1% to 3% of the balance
  • Withdrawing money before age 59 ½ results in a 10% IRS penalty
  • Disbursements are subject to income tax

Benefits

Annuities offer several notable benefits. These include guaranteed income upon retirement, optional add-on benefits, and contributions that grow tax-deferred.

Guaranteed income

While some retirement accounts will eventually run out of funds, an annuity can guarantee income for life—so, even if you live to be 100 years old, you’ll still have a guaranteed income to help pay for your everyday expenses. This is especially important in this day and age, where people are living longer thanks to advances in medicine. An annuity can grant you added peace of mind that you won’t run out of money if you live longer than you expect to.

Riders

Riders are benefits you can add to your annuity—for an additional cost. They can help enhance your annuity to provide even more benefits for your retirement. You can add a rider to guarantee a certain payment amount each month for easier budgeting or to allow a new annuitant to be named upon the original annuitant’s death.

Contributions grow tax-deferred

Similar to traditional 401(k) contributions, you can make pre-tax contributions to an annuity, allowing it to grow tax-deferred. That means you won’t be subject to capital gains tax as your contributions grow in size. Instead, you’ll be taxed when you begin receiving disbursements.

Disadvantages

Although annuities offer several advantages for those saving for retirement, there are several drawbacks to keep in mind. These include annual fees, penalties, and taxes.

Annual fees

Annuities aren’t free; most come with annual fees equal to 1% to 3% of the account balance. These fees are automatically withdrawn from the account each year. As long as your annuity has a higher rate of return, the annual fee shouldn’t make too large a dent in your funds—but if you opt for a variable annuity and have a bad year for returns, you may end up paying more in fees than you make on your money.

Penalties

The IRS imposes a penalty tax on early annuity withdrawals, similar to the penalty for early withdrawals from a 401(k). This will apply if you withdraw funds from an annuity before age 59 ½. While the IRS has several exceptions to the early withdrawal penalty for a 401(k), there are few exceptions for annuities.

Taxes

Although your money will grow tax-free during the contract period, your withdrawals will be subject to income tax. In addition, any money you contribute to your annuity during your working years can’t be used to reduce your taxable income like 401(k) contributions can.

What are the different types of annuities?

There are three different types of annuities to choose from: Fixed, variable, and indexed.

Each can provide a solid rate of return, but some carry a higher risk than others (though, in exchange, there’s the chance for a higher rate of return):

  • Fixed annuity: Pays a guaranteed amount, but you’ll likely have a lower return. However, since fixed annuities are not affected by market changes or inflation, they are the safest option.
  • Variable annuity: Does not pay a guaranteed amount; the funds are invested in stocks, and their value can fluctuate alongside the stock market. However, there’s a potential for a much higher rate of return with a variable annuity.
  • Indexed annuity: Invests in indexes, such as the Dow Jones or S&P 500. This makes them safer than variable annuities but not quite as safe as fixed annuities. In most cases, your rate of return will be decent, but it’s also possible to go years with no returns.

You can also between immediate and deferred annuities:

  • Immediate annuity: Starts payments immediately, making them suitable for those close to retirement age who want to boost their income. However, the return on investment is lower since the money hasn’t had time to earn interest, which can result in smaller payments.
  • Deferred annuity: Payments begin at a future date. Because they are longer-term investments, they have the potential to earn much more interest than an immediate annuity would.

How do annuities payout?

Annuities pay out monthly sums of money, similar to how you would receive a paycheck or regular income from a retirement account. Some annuities will begin payments immediately, while others require the money to be held for a pre-agreed period before payments begin.

In order to start receiving payments, you’ll need to opt in. You can do so at any time after the surrender period is up, but if you opt to receive payments before you reach the age of 59 ½, you’ll also pay an IRS-imposed penalty tax of 10%. Barring a major emergency, it’s best to wait until your 60s to opt into receiving payments from your annuity.

What is the return rate?

There’s no single answer to the question of how much you can expect in returns from an annuity. It depends on the amount of money you deposit and the type of annuity you choose. However, annuities typically have return rates between 4% and 6%—while others may offer returns up to 8%.

In general, the longer the annuity, the more you can expect to make on your investment. Annuities are usually able to withstand fluctuations in the market since they’re a longer-term financial product, so even though you might see a lower return rate some years, you should still make a decent return by the time you retire.

When are annuities a good investment?

If you’re not sure whether an annuity is a good investment, you’re not alone. In many cases, an annuity may not be the best option for your money (such as if you need the money before you retire). However, there are several situations in which an annuity could be right for you:

  • As a supplement to other retirement income. An annuity can be a good supplemental product to an employer-provided 401(k) or a similar retirement product.
  • If you have a large sum of money. If you receive a lump sum of money, you can use an annuity to turn it into guaranteed cash flow over time.
  • If you’ve maxed out your retirement account contributions. Retirement accounts such as 401(k)s and IRAs have contribution limits set by the IRS. If you reach that contribution limit, you can make contributions to an annuity instead.

What are some alternative or complementary investment methods for retirement?

Although an annuity can be a good complement to a retirement plan, experts advise that it shouldn’t be your only source of retirement income. Instead, it’s recommended to use an annuity in addition to an employer-sponsored or individual retirement plan.

Employer-sponsored retirement plans

Many employers offer retirement plans to their employees—most commonly, a 401(k). With this type of account, you’ll typically make pre-tax contributions, and your employer may offer a match, up to a certain percentage of your salary to help your balance grow faster. The money is then invested and grows over time with the idea that it’ll provide sufficient income in retirement when used alongside Social Security and other means of retirement income.

An employer-sponsored retirement plan such as a 401(k) has annual contribution limits set by the IRS. Once you max out your plan, you can decide to put money into an annuity to boost the amount of money available to you in retirement.

Individual retirement plans

Another option to help you save for your golden years is an individual retirement account (IRA) or a Roth IRA. Contributions to the latter are post-tax, which means your withdrawals won’t be taxed when you reach retirement. Anyone can open an IRA since they’re not tied to an employer; however, there is an earning cap that prohibits you from opening an IRA once you reach that cap. IRAs also have annual contribution limits put in place by the IRS.

TIME Stamp: An annuity can help provide supplemental income upon retirement.

An annuity can provide supplemental retirement income to help you pay for living expenses after age 59 ½. There are several types of annuity to choose from, some with higher returns than others—but in general, an annuity can be a good choice for those who want to have an additional income vehicle once they reach retirement age.

Frequently asked questions (FAQs)

What is a fixed annuity?

A fixed annuity is a type of annuity that has a guaranteed payout amount. In exchange for this guaranteed amount, a fixed annuity may have a smaller return on investment than a variable or indexed annuity.

What is annuity income?

Annuity income is the amount of money paid out to you from an annuity once you opt-in. You can do so after you turn 59 ½ (before that, you’ll have to pay an early withdrawal penalty). Annuity income can help supplement your other retirement income from Social Security, a 401(k), an IRA, and similar retirement accounts.

How much does a $50,000 annuity pay per month?

The monthly payments you will receive from a $50,000 annuity will depend on several factors, including the type of annuity you purchase, the contract length, and the age at which you purchase it. However, the following are some examples of monthly payments from an annuity of this size.

  • A 40-year-old who opts into payments at age 65 could get a monthly payment of $900 per month.
  • A 65-year-old who purchases an immediate annuity could get a monthly payment of $247.

Is it better to have a 401(k) or an annuity?

If your employer offers a 401(k), it’s better to max out your contributions to that account before you open an annuity. If you can only afford to have one type of account, a 401(k) is preferred because it comes with additional tax advantages that annuities don’t have.

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