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Annuities can help you protect what matters most as you work towards a long and fulfilling life in retirement. As one of the few investment solutions that ensures you won’t outlive your money, these make a great addition to your portfolio because they offer guaranteed lifetime income when you reach retirement.
If you have ever wondered what an annuity is, or if you’re considering buying an annuity, it’s essential to understand the different types of annuities and how they work. On this page, we provide you with a comprehensive overview of annuities, including what to consider before making a decision. This information should help you decide if an annuity is right for your retirement plan.
What are Annuities?
An annuity is a contract between you (the annuitant) and an insurance company that you can purchase through life insurance agents, financial planners, banks, life insurance companies, or an investment broker. Then, through a combination of savings and investments, you pay a lump sum or series of premium payments to the insurance company. In return, the insurance company provides income payments to you in your retirement, whether periodically or all at once.
The first thing you should know about annuities is the widely varying terms and differing costs. In addition, most annuities offer tax advantages with your investment earnings growing tax-free until you start to withdraw the income. Some provisions penalize you if you withdraw funds early. However, most allow you to make withdrawals for qualified purposes without penalty. Here are a few main points about annuities to keep in mind:
- The goal of an annuity is to provide a steady stream of income, typically during retirement, with many aspects of the annuity tailored to the specific needs of the buyer.
- Annuities provide a fixed monthly income either for a set period or for the rest of your life. The monthly lifetime payments are determined by your age at purchase and your life expectancy.
- An annuity should not be your sole source of retirement income, as inflation reduces its value over the years.
- There are four different types of annuities—immediate, deferred, fixed, and variable— in three main varieties—fixed, variable, and indexed. Each has its level of risk and payout potential.
How do annuities work?
Annuities alleviate the fear of outliving your assets. As a long-term contract between you and an insurance company, you invest your money, and in return, you receive income in the form of regular payments. The money you invest builds in value and supports you by assuring income if you outlive your savings. The primary benefits of annuities include:
- Predictable payments—Annuity income payments may be guaranteed for a set period of time, or until death, or the death of your spouse or another beneficiary.
- Tax-deferred growth—money paid into an annuity grows on a tax-deferred basis, so when you receive annuity payments, the earnings portion of your payments is taxed as ordinary income, while the principal is generally free of tax.
- Death benefits—depending on the type of annuity, a named beneficiary can receive payments after you pass away.
How you build your retirement funds and cash value and then convert those funds into guaranteed income will depend on the type of annuity you purchase. Once you choose the type of annuity that is right for you, you can receive payments based on the terms of your contract without any additional effort.
Who qualifies for annuities?
Annuities provide peace of mind for those who don’t have a fixed income planned for their retirement. The various options offer flexibility for different life stages and situations. So, you should consider adding an annuity to your retirement plan if you are:
Between 70 and 75
Most financial advisors will tell you that the best age for starting an income annuity is between 70 and 75, which allows for the maximum payout.
Anticipating longer life expectancy
If you’re a healthy individual who expects a long life ahead, annuities can be good protection against outliving your savings.
Already maxed out with other investment vehicles
If you have additional money to set aside for retirement, an annuity's tax-free growth may make sense, especially if you’re in a high-income tax bracket.
Different Types of Annuities
In order to understand annuities, you need to learn about the different types of annuities and how they differ from each other. Four basic types of annuities are designed to meet your specific needs and allow you to purchase one that best fits your comfort level: immediate, deferred, fixed, and variable. These offer unique features serving different purposes but are based on when you want to begin receiving payments and how you would like the annuity to grow:
When you begin to receive payments: You can receive annuity payments immediately after paying the insurer a lump sum (immediate) or by receiving monthly payments in the future (deferred).
How you want your annuity investments to grow: Annuities can grow in different ways—through interest rates (fixed) or by investing your contributions in the market (variable).
Immediate annuities are the lifetime guaranteed option, designed to provide you with guaranteed lifetime income payments in exchange for an initial lump-sum investment. Individuals at any age who have received a large sum of money, such as a settlement or lottery win, may purchase a lifetime guaranteed option to convert this sum into a stream of future cash flows. This type of annuity starts immediately since you’re trading liquidity for guaranteed income. The amount of the payments you receive is calculated by the insurer based on your age, prevailing interest rates, and how long the payments will continue. As the annuitant, you will know exactly how much you will receive in the future, for the rest of your life.
Deferred annuities are a tax-deferred option that provide you with guaranteed income in the form of a lump sum or monthly income payments on a future date. These annuities come in several different forms, including fixed, indexed, and variable, which determine how your rates of return are compute.
Fixed annuities are a relatively lower risk option when it comes to annuities because they act like a savings account. They provide you with a fixed minimum interest rate and a fixed schedule of payments over your retirement, whether it’s for 5, 10, or 20 years. Depending on the details of the annuity contract, a fixed annuity could pay more when investments earn higher returns. During less profitable years, you receive the guaranteed minimum amount of income. So, the guaranteed annual minimum income doesn’t depend directly on market performance. Fixed annuities are the safest option for individuals later in life, where income protection and disbursement are most important.
Variable annuities are the highest upside option, as they depend on market performance. These types of annuities also depend on two factors: the principal, or the amount of money you pay into the annuity, and the returns that your annuity’s underlying investments deliver on that principal over time. Variable annuities act like an investment account, providing you with a variety of options to invest your money to grow tax-deferred and provide a death benefit for your family. They offer the possibility of higher returns and greater income than other types of annuities, but there’s also a risk that the account will fall in value. They are most appropriate for individuals with a longer time frame (at least 15 years or less) before the income is needed.
There are over $200 billion in annuity sales every year. When done right, annuities can help provide you with cash for your later years. No one should live in fear of outliving their hard-earned income, and annuities offer a sense of income confidence. Therefore, they make sense as part of your overall retirement plan, especially if you’re concerned about outliving your assets.
As you decide between the different annuity options, use the following takeaways as further research on deciding which annuity is best for you:
- Annuities are insurance contracts that promise to pay you regular income immediately or in the future.
- There are four types of annuities—immediate, deferred, fixed, and variable.
- Immediate annuities pay income right away, while deferred annuities pay at a future date.
- Fixed annuities are insurance contracts that pay a guaranteed interest rate on the account owner’s contributions.
- Variable annuities pay a rate that varies according to the performance of an investment portfolio
- Deferred annuities are insurance contracts that promise a regular income or a lump sum of money at a future date.
- Annuities provide tax-deferred investment growth, but the owner has to pay income taxes on the money when it’s withdrawn. Most annuities penalize early withdrawals, with sometimes high fees.
Annuities are taxed differently, based on when funds are withdrawn from them. Funds withdrawn before age 60 will face penalties while funds withdrawn afterwards will be taxed as income depending on how they were purchased.
One of the main disadvantages with annuities is the lack of control over funds and the length of time required to see a significant return or benefit. Annuities make it challenging to liquidate funds given their long term nature.
Most people will experience the most benefits from an annuity if they buy it after age 45. Younger investors may see more return on other types of investments and will have more control and flexibility over their assets.
Qualified annuities are annuities that are taxed when payments are made to the owner, non-qualified annuities are purchased using income that has already been taxed and allow for tax free payments once the buyer begins receiving payments.
The amount that an annuity will pay monthly will vary widely depending on the size of the annuity purchased, the age of the buyer when it was purchased, and the length of time since purchase that they begin receiving payments.
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