Annuities are often marketed as part of a smart retirement plan. The biggest selling point is guaranteed income. You pay the insurance company, and in return, they pay you for the rest of your life. You may even be able to retire early .
However, there are many details about this financial instrument that you need to understand before you invest a chunk of your retirement savings.
Let’s examine how annuities work and why you may want one.
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1. What is an annuity?
An annuity is a financial product you purchase from an insurance company. You enter into a contract that essentially states you'll put money into the annuity, and when you retire, the insurance company will pay you back in monthly installments for the rest of your life.
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2. How does an annuity work?
When you purchase an annuity, you must fund it. This can be done with either a lump sum or through installment payments paid to the insurance company.
Over time, the annuity grows in value, either with interest or based on how well investments perform, depending on the type of annuity you purchase.
Once the annuity reaches maturity, you convert the annuity (also called annuitization) and the account begins to pay you income.
3. What is annuitization?
Annuitization is when you convert the money you've accumulated inside your annuity from growing to paying out. Once you annuitize, you will receive payments for a set period of time.
It could be a certain number of years or for the rest of your natural life. Each annuity is going to have its own specifications.
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4. What kinds of annuities are there?
There are three main types of annuities: fixed, variable, and indexed.
A fixed annuity is just like it sounds: Your money earns interest at a fixed rate. With a variable annuity, your money is invested in stocks and bonds, so your payments can vary based on how well these investments do.
An indexed annuity is tied to the performance of a specific market index, like the S&P 500.
5. What is the difference between an annuity and life insurance?
Both products are sold by insurance companies, however, an annuity is to protect your income during your life and life insurance is to protect your income for your family in the event of your death.
Both products are structured around a person’s life expectancy. Life insurance is predicting you will live and continue making payments, while an annuity provides an income for your life in retirement.
6. What are the benefits of an annuity?
Owning an annuity can offer you an additional source of income during retirement. Retirement accounts and Social Security may not be enough to sustain your lifestyle.
Annuity payments are often issued for the rest of a person’s natural life, offering protection against outliving savings or other retirement accounts.
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Annuities have a number of drawbacks. They are issued by an insurance company, so commissions and annual management fees may reduce earnings.
It's not easy to withdraw money from an annuity before age 59 1/2, and if you do, you’ll likely be hit with penalty charges. The IRS charges a 10% early-withdrawal penalty for funds taken before the annuity holder reaches age 59 1/2.
Also, annuity return rates may not always keep up with inflation, so your buying power could be reduced.
8. How are annuities taxed?
If you put pre-tax money into your annuity, then you will pay taxes on the money as it is paid out, just as you would with a traditional IRA.
This can work to your advantage if you're in a higher tax bracket when you purchase the annuity but in a lower tax bracket when you withdraw the money.
If you already paid tax on the money before you put it into an annuity, then you'll only pay taxes on the earnings.
9. What are the fees associated with annuities?
Typically, the more complicated the annuity, the more it costs. The person who sells you the annuity will likely be paid a commission ranging anywhere from 1% to 10% of the value.
There may also be annual fees for managing your account, ranging from 0.5% to 1.5% of the annuity’s value. There can also be penalty fees if you cancel your contract or take money out early.
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When the owner of an annuity passes away, the annuity’s terms determine what happens next. If the owner chose a simple single-life payout option, then the annuity payments typically stop.
However, if the owner selected a joint-life or beneficiary payout option, the remaining value of the annuity may go to an assigned person.
11. Can annuities be passed on to beneficiaries?
Yes, annuities can be passed on to beneficiaries, depending on the type of annuity you purchased and the terms of your contract.
If your annuity allows the value to be passed to someone else, your beneficiary could be paid in a lump sum, monthly payments, or continue the annuity through the end of their life.
12. Are there any penalties for withdrawing money from an annuity early?
Like certificates of deposit (CDs) or an IRA, there can be penalties for withdrawing money from an annuity early. These are known as surrender charges and are in place to discourage you from making early withdrawals.
Like other retirement accounts, withdrawals made before age 59 1/2 may also be subject to a 10% federal tax penalty.
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Annuities can provide a steady, reliable income stream during retirement. If you're planning your retirement , an annuity can bring peace of mind that you can live the lifestyle you want.
But not everyone needs an annuity. If you have a pension, strong retirement accounts, or are in poor health, an annuity may not be the right choice. Annuities are financial contracts and should not be entered into lightly.
Money tips that can work for everyone
No matter what your bank account balance is, there's always an opportunity to optimize and improve your finances. Here's a quick checklist of things you can look at today.
Focus on paying off your debt. Debt can hold you back from making progress with your overall financial well-being. Aside from cutting expenses, there are tools that can help you pay off debt faster like balance transfer credit cards and debt counseling.
Earning extra income can give you breathing room. If finances are tight, earning some extra money to supplement your income can make a huge difference. A new job is one option to consider, but if you're not ready to make a big change or already retired, a part-time side job could be a better choice.
Cut your expenses. It sounds painful and so not fun, but it doesn't have to be. Take a look at your biggest expenses because that's where you'll probably find the biggest savings. For example, auto insurance rates have been soaring so shopping around for a new insurance company can be the fastest way to cut your bill. Also, look for ways to cut your grocery bill (despite rising inflation).
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