The Pros and Cons of Buying an Annuity For Retirement

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Most Americans build retirement savings through individual retirement accounts or employer-sponsored plans such as 401(k)s. But another option is an annuity, which is designed to provide a steady source of income throughout your retirement.

You have a few different choices when it comes to choosing the right annuity for your purposes. Keep reading to learn more.

What Is an Annuity?

The U.S. Securities and Exchange Commission describes an annuity as a “contract between you and an insurance company that is designed to meet retirement and other long-range goals.” How should you fund an annuity? You can start with a lump-sum payment, or opt for installment payments. Your annuity insurer will then issue payments, either at the beginning of the term or on a different date.

One advantage of an annuity is that it offers tax-deferred earnings growth. In some cases, you might also get a death benefit that pays beneficiaries a specified minimum amount, such as your total purchase payments. Once you start making withdrawals from the annuity, any gains are taxed at the ordinary income rate.

An important thing to keep in mind is that if you withdraw your money early from an annuity, you could face surrender charges to the insurance company as well as tax penalties.

Here’s a break down on some more of the pros and cons of annuities.

Pros of Annuities

These are some of the pros to consider when you have an annuity.

Guaranteed Income

One of the main advantages of an annuity is that it is set up to provide monthly payments during retirement, which guarantees income over a certain number of years.

Tax Advantages

With an annuity, contributions are tax-deferred, so you won’t owe taxes on the money until you start getting payments. This means your contributions have a chance to grow tax-free, similar to a 401(k).

Protection Against Market Volatility

Because rates of return for fixed annuities are guaranteed, they provide predictable and a steady stream of payments to add to your retirement fund. Fixed annuities pose little financial risk because your interest rate is locked in, meaning you are guaranteed a payment during the payout phase.

Estate Planning Benefits

You will typically get a standard death benefit with most annuities. This means your heirs will receive a payout if you pass away before taking withdrawals.

Cons of Annuities

Just as there are pros to an annuity, there are some cons to consider as well. Take a look at some of these below.

High Fees and Costs

You will face fees with an annuity that vary by the issuing company. Fees are typically anywhere from 1% to 3% of your account balance per year. Most issuers will also charge other fees, such as early withdrawal fees or fees for optional riders.

Limited Liquidity

Many annuities come with early withdrawal penalties, which means if you withdraw money before the term ends, you could face surrender charges and tax penalties. Therefore, you aren’t able to withdraw the money as quickly as you would another type of savings option.

Complex Terms and Conditions

Annuities can be difficult to understand or even start investing in, so it’s never a bad idea to consult with a financial professional to help you. You’d need to factor that cost in as well.

Inflation Risk

Your money in an annuity account is a fixed payment. While it’s nice to have a guaranteed option, inflation could lessen the value of these payments over time, as the price to buy items and the overall cost-of-living could outgrow what your annuity can provide.

Also, the money in your annuity is not guaranteed by the FDIC, Securities Investor Protection Corporation or any other federal agency.

Potential Low Returns

This mainly applies to variable annuities, which don’t have guaranteed rates of return and instead depend on the performance of underlying investments to earn money. If the performance is negative, you could lose money.

Is an Annuity Right for Your Retirement?

The main purpose of an annuity is to remove longevity risk for retirees, meaning you don’t have to worry about outliving your retirement savings. This is an especially important consideration given that people are living longer now.

An annuity is an especially good option for those who are approaching retirement age, are expected to live a long time, and have a decent nest egg saved up. It might not be a great fit if you don’t have much retirement savings because there is some risk involved.

There are many pros and cons of annuities to consider. For one, annuities offer a tax-deferred way to grow your retirement savings and can be a great option for guaranteeing a source of monthly income in your golden years.

Depending on the type of annuity, however, you could face hefty fees and potential losses. Read the fine print before signing an annuity contract — you’ll want to make sure you know exactly what to expect.

Melanie Grafil contributed to the reporting for this article.

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