Annuities are investment products designed to grow your funds and provide you with a stream of income at some point, typically after you stop working. If you’re thinking about retiring, you might consider one of these tax-deferred annuity investments.
The pros and cons of annuities are extensive but the way they work is pretty straightforward. If you decide this option is right for your retirement savings plan, read your annuity contract thoroughly to avoid getting hit with surprise fees.
What Is an Annuity?
Simply put, an annuity is an insurance product that can be purchased to provide a sum of money either in the form of a lump-sum or ongoing contributions, such as in the form of monthly or annual payments used as income in retirement.
How Do Annuities Work?
Two broad types of annuities exist — fixed and variable — and each contains a number of subcategories. Although their details might vary, this is generally how annuities work:
- You purchase an annuity from an insurance company with either a single payment or ongoing contributions.
- The money in your annuity account grows at either a fixed or variable rate during what’s known as the accumulation period.
- You can withdraw the funds during the annuitization period — a timeframe you choose — and take your payout in a lump sum or convert it into an income stream.
Each annuity offers various payout options. For example, a lifetime payout annuity’s payments end after you die. A joint-and-survivor annuity pays you and after your death, pays your designated partner for the rest of his life.
Types of Annuities
You can choose from two primary types of annuities: fixed and variable. Learn more about each type of annuity to find out which is right for you. Here’s the difference between the two types of annuities:
During the accumulation period, a fixed annuity credits a specified rate of interest to the account. Upon annuitization, you receive payments based on the total value of the annuity.
You can choose from two types of fixed annuities: immediate and deferred. If you choose an immediate annuity, annuitization occurs shortly after you purchase it, sometimes within 30 days. Because there’s no time for interest to accrue, you’re essentially converting your premium payment into an income stream.
A deferred income annuity earns interest during the accumulation period. It annuitizes — and stops earning interest — at a specified future date. At that point, you can choose a lump-sum withdrawal or convert the account value into an income stream.
Variable annuities’ interest rates are based on their underlying investment accounts, known as subaccounts. The accounts are similar to mutual funds in that they offer a range of different investments, such as large-cap stocks or international bonds. When you annuitize a variable annuity, the amount you receive depends on how the account you selected performed.
Equity-indexed annuities are hybrid investments that blend features of fixed and variable annuities. They typically guarantee some minimum return but are linked to the performance of a particular index, such as Standard & Poor’s 500 index.
Most insurance companies offer riders — enhancements that meet an individual’s specific needs — for their annuity contracts. For example, some variable annuities can lock in a death benefit — at various times during the contract — that protects you from future declines in the account’s value. A guaranteed minimum rate of return on an account is another type of rider you can purchase.
Fees and Penalties
Any money in an annuity grows tax-free during the accumulation phase. Upon annuitization, however, the IRS will collect taxes on withdrawals. If you take earnings out of an annuity before you turn 59.5, you’ll also owe the IRS a 10 percent early withdrawal penalty.
Beyond those IRS regulations, annuities typically carry some or all of the following charges:
- Insurance charges: Also known as mortality and expense charges, these fees pay for the insurance cost of the annuity.
- Surrender charges: You’ll have to pay these fees if you make withdrawals above certain amounts.
- Investment management fees: Because you choose subaccounts for variable annuities, you’ll have to pay an investment management fee or administration fee, which can range from 0.25 percent to 2.00 percent — per year — of the account’s value.
- Rider charges: Contract enhancements are available but cost extra.
Choosing the Right Annuity for Your Retirement Plan
Investors typically use income annuities as supplemental retirement income for Social Security benefits and pensions. Unlike other tax-advantaged retirement options — such as IRAs and 401ks — there’s no limit on the amount you can invest in a retirement annuity. Annuities serve as additional savings options for investors who have already maxed out other retirement strategies.
You can customize annuities in a number of ways, so ensure the one you choose meets all your investment needs. Whatever type of annuity you choose, carefully review the fee structure to make sure you’re getting more money out of the contract than you’re putting in.