Annuities are one of the few investment solutions that ensure you won’t outlive your money, and are a great addition to your retirement portfolio. That’s because they offer a guaranteed lifetime income when you reach retirement! No one should live in fear of outliving the money they worked so hard to accumulate, and annuities help protect what matters most as you look forward to a fulfilling retirement.
With over $250 billion in annuity sales each year, there remains confusion and controversy around this particular financial instrument. To alleviate that confusion, we set out to provide an extensive guide to annuities, including what they are, how they work, and how they differ from other types of investments.
What Are Annuities?
Annuities are a long-term financial vehicle designed to provide guaranteed lifetime income after retirement through a combination of savings and investments. They are contracts sold by insurance companies that promise the buyer (known as the annuitant) a future payout through one-time or monthly installments, usually for life.
The annuitant pays premiums in exchange for the insurance company to take on the risk of providing a monthly income stream for the rest of their life (and sometimes carried over to beneficiaries). A variety of contract provisions (known as riders) can also be purchased to modify and customize the annuity. Similar to other types of retirement investments, they are funded by payments the owner makes during their working years, and after retirement they are paid out at regular intervals.
How Annuities Work
Designed to provide a steady and guaranteed cash flow for the annuitant during their retirement, annuities alleviate the fear of individuals outliving their assets. As a long-term contract from an insurance company, the annuitant invests their money and in return, they receive income in the form of regular payments. The money invested builds in value and helps support the annuitant by providing them assurance of income if they outlive their savings.
Most of the time, the annuitant is an individual investor looking for stable and guaranteed retirement income. Annuities typically aren’t recommended for younger individuals, who should first address more immediate and pressing needs––such as paying down student loans, credit card debt or other loan balances, thereby minimizing interest charges––before tying up money in an annuity.
Annuities have two phases:
- The accumulation phase is when an annuity is being funded and before payouts begin. Any money invested in the annuity grows on a tax-deferred basis during this stage.
- The annuitization phase (sometimes referred to as the distribution phase) is the period when the annuitant starts receiving payments from their annuity investment.
What Are the Different Types of Annuities?
There are several types of annuities, each with unique features serving different purposes, allowing the buyer to select the one that fits their needs and comfort level. Annuities can be created to last as long as either the annuitant or their beneficiaries are alive or can be structured to pay out funds for a fixed amount of time. Once you choose the type of annuity that’s right for you, you will receive payments based on the terms in your contract.
The four basic types of annuities are: immediate, deferred, fixed, and variable. They are based on when you want to start receiving payments, and how you would like your annuity to grow.
- When you begin receiving payments. Annuity payments can be received immediately after paying the insurer a lump sum (immediate) or by receiving monthly payments in the future (deferred).
- How your annuity investments grow. Annuities can grow in different ways—through interest rates (fixed) or by investing your contributions in the market (variable).
Immediate annuities are often purchased by individuals of any age who have received a large lump sum of money (a settlement or lottery win) and prefer to convert this single amount into a stream of future cash flows. This method starts immediately, provides a guaranteed lifetime payout, and is best suited for those who want a secure lifetime income. Generally, you won’t have access to that full lump sum in the case of an emergency, since you’re trading liquidity for guaranteed income. Immediate annuities are unique because fees are taken out of the payments. The annuitant knows exactly how much they will receive in the future, for the rest of their life.
Deferred annuities are a savvy option for those looking to contribute to their retirement income on a tax-deferred basis—meaning you won’t have to pay taxes until you take money out and when you are likely in a lower income bracket, much like a 401(k) or an IRA. This type of annuity provides you with guaranteed income in the form of either a lump sum or monthly income payments on future dates. Unlike another form of savings/income vehicle, the traditional 401(k), deferred annuities don’t have contribution limits. The amount your principal grows before you start receiving payments will depend on selection of the investment type.
As a lower risk option, fixed annuities act like a savings account or CD providing the annuitant with a fixed minimum interest rate and a fixed schedule of payments over their life. The interest rate can last anywhere between a year and the full-length of the guarantee period. The earnings are tax deferred until the annuitant begins receiving the payments. This method is better used for growing income in the accumulation phase, not for generating income in retirement. While you cannot say how long you’re going to live, fixed annuities are most appropriate for individuals at a later stage of life where income protection and disbursement are most important.
Variable annuities act like an investment account providing the annuitant with a variety of options to invest their money to grow tax deferred and provide a death benefit for the annuitant’s family. This method allows you to invest your money into sub-accounts that, over time, help you keep up with or even outpace inflation. Like mutual funds, sub-accounts are dependent on market risk and performance. They are most appropriate for individuals with a longer time frame (at least 15 years or less) before the income is needed.
How Do Annuities Differ from Other Types of Investments?
Annuities, IRAs, and 401(k)s are forms of retirement plans but they have significant differences:
- 401(k) plans are available to individuals whose employers offer them, while annuities aren’t employer-sponsored and can be purchased by anyone.
There are contribution limits for 401(k) accounts, but none for annuities.
- Contributions to 401(k) accounts may be deducted from your taxes in the years in which they are made, while contributions to annuities may not be tax deducted.
- Withdrawals from 401(k) accounts are taxable in their entirety, while only the portions of annuity payments that represent earnings are taxable.
- IRAs are tax-advantaged retirement account established by an individual who can make their own investment decisions or hire a licensed professional to manage the account for them.
- Contributions to an IRA are typically tax deductible subject to income limits.
- The funds grow in the IRA tax-deferred, but once the owner becomes age 72 they must start taking Required Minimum
- Distributions (RMD) withdrawals that are subject to taxes on the gains (but not the principal that was contributed).
- Any funds taken out prior to the age 59½ are subject to early-withdrawal penalties up to 10% as well as federal and state tax penalties.
There are specific circumstances that will allow for penalty free withdrawals from an IRA or a 401K including:
- Inherited account
- Buy, Build, or Rebuild a Home
- Fulfill an IRS Levy
- Unreimbursed Medical Expenses
- Health Insurance Premiums While Unemployed
- Permanent Disability
- Higher-Education Expenses
Some individuals choose to roll all or part of their IRA or 401(k) savings into annuities as a means of providing a stream of income to fund their retirement.
Annuities also differ from traditional investments. Investments happen when money is put into a product such as a stock, bond, mutual fund or even a home mortgage or bank savings account in the hope of making more money over time. An annuity is a type of investment product sold by life insurance companies.
Who Are Annuities Best For?
The answer to ‘who annuities are best for’ is entirely dependent on your situation. If you have health issues that could affect your longevity so that it’s unlikely you’ll outlive your savings and expect you’ll need liquidity to pay medical bills, annuities may not be the best option for you. If, on the other hand, you’re a healthy individual who anticipates a long life ahead, annuities can be good protection against outliving your savings. Especially if you’re older, the safety and predictability of annuities are likely to be suited to your needs. They provide peace of mind for those who don’t have a fixed income planned for their retirement, and the various options offer flexibility for different life stages and situations.
If you’re years away from retirement, the higher potential returns of a variable annuity could be your optimal choice, but those closer to retirement may want to go with a shorter-term fixed annuity that safely grows based on a set interest rate.
How Are Annuities Different from Life Insurance?
Life insurance deals with the risk of an individual dying prematurely. Policyholders pay an annual premium to the insurance company who pays out a lump sum upon the owner’s death. If the policyholder dies prematurely, the insurance company pays out the death benefit at a net loss.
Annuities deal with longevity risk, or the risk of outliving your assets, and are intended for retirement purposes. The risk to the issuer of the annuity is that the annuitant will outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.
Annuities are not the only financial planning strategy for generating income in your retirement. Alternatives can include bonds, certificates of deposit, retirement income funds, dividend-paying stocks, reverse mortgages, and life settlements.
A life settlement is a cash payment in exchange for selling your life insurance policy, which can be a solution to help alleviate debt, maintain a better quality of life, or put toward an income vehicle, such an annuity. Policyholders who no longer need their life insurance policy, or for whom the premiums have become too expensive, can sell their life insurance contract to a third-party buyer, such as a life settlement provider. To qualify for a life settlement, you need to be over the age of 65, your life insurance policy must have been active for at least two years and have a minimum death benefit of $100,000.
How to Fund an Annuity
A life settlement is a savvy way to help fund an annuity. By selling your life insurance policy in return for a life settlements you realize value out of a policy you can no longer afford to keep or want to cancel . The proceeds from the life settlement can then be used toward purchasing an annuity, converting what was once an expense into an income stream. All life insurance policies are unique, so your life settlement payout will differ depending on the value of the policy and the sale offer.
Annuities can help you achieve your retirement goals and, when done strategically, can help provide cash for your later years. It can be difficult to think of how long you will live, and challenging to predict how long your savings will last. Annuities offer a smart option for aligning with your goals and values, and helping you insure your future needs are financially covered. A talk with your financial advisor can help you decide if annuities, and what kind, are right for you. Contact the experts at Retirement Genius today.