- An annuity is an insurance investment that provides a steady source of income during retirement.
- An annuity charges a premium upfront with other management fees often rolled into the cost.
- Fixed, variable, and indexed annuities offer different investment options with varying risk profiles.
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When you’re saving for retirement, it can be difficult to know whether you’re saving enough. Even if you think you’ve got it covered, there’s little accounting for how much you’ll actually spend in retirement or how long your retirement will be.
That’s where annuities come in. These unique combinations of insurance and investment features help investors save for retirement and offer assurance they won’t outlive their hard-earned assets.
Learn more about annuities below and what you’ll want to take into consideration before you add them to your portfolio.
What is an annuity?
An annuity is an investment you buy in exchange for periodic payouts, typically during retirement. You can make a single premium payment or a series of payments, and choose whether your annuity payouts are made in a lump sum or over time.
How do annuities work?
A modern-day annuity is a contract between you and an insurance company. In order to get an annuity, you’ll need to pay a premium – usually a large lump sum – and then the insurer invests it. Afterward, the insurer provides you with a stream of payouts for a predetermined number of years or even the remainder of your lifetime.
An annuity has two phases: the accumulation phase and the annuitization phase. The accumulation phase of an annuity is the period of time when you’re making payments. Those funds may be split among various investment options.
The annuitization phase is the period of time when you receive payouts from the annuity, much like a regular paycheck. This can last for a set amount of years or for the rest of your life. The payouts include the principal amount along with any investment gains.
Annuities provide a stable investment option for savers who worry about market volatility or outliving their retirement savings. Annuities are known for three main benefits.
- Reliable income for a set amount of time. Once you’ve made your payments, you’re guaranteed to receive payouts for the rest of your life or someone else’s life, like your spouse.
- Death benefits. You may also designate a beneficiary on your annuity. This beneficiary will receive the payouts if you die beforehand.
- Tax-deferred savings. Before you start receiving payouts, annuity income and investment gains grow tax free. “Annuities complement other retirement plans in that they provide opportunities to grow without heavy taxation,” says Rob Williams, managing director of financial planning, retirement income, and wealth management at Charles Schwab. You pay taxes on annuity income when you receive its payouts.
What are the different types of annuities?
Different types of annuities vary in how your money is invested.
- Fixed annuities place your money in a general account of the insurance provider which promises a minimum rate of interest and fixed amount of periodic payouts. Check with your state insurance commission to confirm your insurance broker is registered to sell fixed annuities.
- Variable annuities place your money in various investments, like mutual funds, much like a 401(k). The payouts from variable annuities will vary depending on how much money you pay, the rate of return on your investments, and any expenses of those investments as well as the annuity. Variable annuities are regulated by the Securities and Exchange Commission (SEC).
- Indexed annuities provide the positive investment potential that variable annuities offer. The return of an index annuity is based on a stock market index, like the S&P 500. Like fixed annuities, these are regulated by state insurance commissioners.
Pros and cons of annuities
At their core, annuities are full of advantages:
- Regular payments. They provide a guaranteed source of income throughout your retirement.
- Low-risk returns. Annuities are generally a more stable investment, unless you have a variable annuity.
- Tax-deferred growth. Earnings in your annuity are untaxed as they grow over time.
Unfortunately, there are major drawbacks to consider as well:
- Big fees. Annuities typically have high fees and commissions which can really cut back on the long-term earning potential. Because of this, annuities aren’t a great place to grow money, but fixed immediate annuities take a smaller fee hit while generating a lifetime income stream.
- Illiquidity. Variable annuities don’t offer access to your money until after several years, typically six to eight years but sometimes longer. If you do withdraw funds or cancel your annuity contract before that surrender period ends, you incur a surrender fee that can initially reach as high as 10% of your contributed funds, decreasing by one percentage point each consecutive year. Once your payouts start, it’s next to impossible to change them or access more of your principal.
- Taxable income and tax penalties. Annuities aren’t totally tax free. As a source of income, annuity payouts are subject to income tax as you receive them. If you withdraw from your annuity before you’re 59 ½, you’ll face a 10% penalty on top of your ordinary income tax as well.
The financial takeaway
Annuities are a great addition to your retirement savings plan if you’re always maxing out your 401(k) contributions and if you can afford the fees. They provide steady income throughout your retirement, they grow tax-free, and your beneficiaries can benefit from the payouts, too.
Since annuities aren’t free, however, be sure to weigh their costs against their promised benefits to determine whether it’s the right choice for you.