If the idea of tying your retirement savings to the ups and downs of the stock market makes you nervous, you have the option to invest in an annuity with your insurance company. Annuities provide a guaranteed monthly income for your lifetime during retirement.
Just make sure you understand how an annuity works so you can get the most out of it without compromising on your retirement goals.
What's in this guide?
- What is an annuity?
- How do annuities work?
- What are the payment terms for annuities?
- How is an annuity different from other investments?
- Compare the different types of annuities
- What kind of riders are available with an annuity?
- Types of annuity payouts
- Pros and cons of annuities
- Are annuities worth it?
- Compare alternatives to annuities
- Bottom line
- Frequently asked questions
What is an annuity?
An annuity is essentially a pension fund that you set up with your insurance company. You invest money through your insurance company, and when you retire, you get guaranteed monthly income payments in return.
How do annuities work?
You buy an annuity in the same way you purchase a life insurance policy — setting the amount you’ll pay in premiums based on how much you need to save in order to get the monthly income you need in retirement. You can also choose to buy an annuity with a lump sum amount like a settlement or inheritance.
Once you start paying into the annuity, the insurance company invests the money for you so that your annuity grows. Once you retire, you decide when to start your monthly payments and whether you want those to be paid for your lifetime and the life of your spouse, or whether you want to have the income for a set term.
What are the payment terms for annuities?
There are three common payment terms:
- Life-only annuity. With this annuity, the payments are guaranteed to continue until your death — so it typically provides a higher income stream than annuities with other payment terms.
- Joint-life annuity. Designed for couples, these annuities pay out as long as either spouse lives. You can also decide which percentage of the benefit will go to the surviving spouse — for example, 50% or 100% — and this will then determine the monthly income earned.
- Term certain annuity. This annuity guarantees payment for a set number of years, like 10 or 20. If you pass away before that period is up, the payments will go to your beneficiary for the remainder of the term.
How is an annuity different from other investments?
Annuities are similar to other retirement accounts but have higher fees, higher taxes and more complex benefits. You’ll pay more in account management fees than most 401ks. And you might pay for your annuity with pre-tax or post-tax dollars, which affects the amount your payouts will be taxed.
For most people, an annuity offers fewer benefits than other investments. However, an annuity might be a good choice for you if you’d prefer to get a set amount in retirement and not worry about making decisions to withdraw from your other retirement accounts.
What taxes do I pay on my annuity withdrawals?
The IRS treats your monthly annuity payments as regular income and taxes them that way. But you only pay taxes on the part of your annuity that is the result of growth.
The premiums you pay into the annuity are considered income that’s already been taxed. Once the funds in your annuity account drop below the amount you paid in, you no longer have to pay taxes on your withdrawals.
For example, if you paid $50,000 in premiums into your annuity, and it’s worth $80,000 when you retire, you’ll start off treating each monthly payment as taxable income. When the fund drops below $50,000 in available funds, the payments you receive are no longer considered taxable income.
Compare the different types of annuities
You have a few annuity options, so choose the one that works best with your retirement goals.
- Fixed annuities. With this investment, your payout is guaranteed because the growth is guaranteed. A fixed annuity is more similar to a bank CD than investing in the stock market or a mutual fund, offering a safe investment with a modest but reliable payout.
- Variable annuities. You can get a higher return with a variable annuity, but it also carries a higher risk. You decide how you want to invest your money, choosing from a set of mutual funds, and the payments you receive in retirement are based on how well your investment performs.
- Indexed annuities. Investing in an indexed annuity allows your money to grow based on the performance of a stock market index, such as the S&P 500.
Annuity comparison chart
|Guaranteed monthly income for you and your spouse|
|Cost-of-living adjustments (rider)|
|Guaranteed minimum withdrawal benefits (rider)|
|Guaranteed minimum accumulation benefits (rider)|
|Protection against market losses|
|Potential to leave a legacy to heirs|
What kind of riders are available with an annuity?
The riders available to you depend on the insurance company where you invest and the type of annuity you choose. Some of the more common riders on annuities include:
- Disability or terminal illness. If you become disabled or are diagnosed with a terminal illness while you’re still paying into the annuity, this rider allows you to withdraw from the premiums you paid without having to pay the surrender penalty.
- Long-term care. Provides additional income to cover long-term care costs, whether you’re receiving in-home care or are in an assisted living environment.
- Cost of living increases. With this rider, your monthly income increases by a set percentage every year to keep up with the cost of living.
- Guaranteed minimum accumulation benefits. Mitigates the higher risk of variable annuities. If you have this rider, the value of your account is guaranteed not to fall below the amount of premiums you’ve paid into it. For example, after five years, if you paid $50,000 of premiums into your account and the account takes losses so that it’s only worth $45,000, the money will be restored to be worth the $50,000 you’ve paid into it.
- Guaranteed minimum withdrawal benefits (GMWB). Also guarantees the value of your premium payments, but using a different method. If you have the GMWB rider, you can withdraw a set percentage from your annuity each year until the amount you paid in premiums is depleted.
Types of annuity payouts
In addition to selecting a type of annuity, there are a couple of ways you can choose for it to be distributed:
- Immediate or deferred annuities. If you put a large lump sum into an annuity, you can choose whether to start your payments after one year, or defer your payments to start sometime in the future. As with all retirement funds, if you choose to start taking payments before you’re 59 ½, you’ll have to pay a 10% penalty on your withdrawals.
- Lifetime or fixed period annuities. Choose whether to have your payments spread out over your lifetime or to take them for a fixed amount of time, such as 15 or 25 years.
You’ll also want to choose whether to invest one large lump sum in an annuity or to make payments over a period of time.
Pros and cons of annuities
- Guaranteed monthly income. The money you invest comes back to you as monthly income, which can help you maintain your lifestyle into retirement.
- Cover your expected expenses. Some people don’t need a monthly income from their annuity, but want to use their withdrawals to help cover a bill or set of bills. For example, if your property tax bill comes annually, you can choose to have your annuity pay out the amount of the tax bill on an annual basis to make sure you always have the money to cover it.
- Customizable options. You choose when to start taking your annuity payments, for how long and how you’ll leave the money to your beneficiaries when you die. You can also choose from a variety of riders to customize your annuity to your needs into retirement.
- Not easily available for emergencies. Once the terms of your annuity are set, your money’s locked in. If you have an emergency and need to take money out of your annuity to help, you’ll have to pay a “surrender fee,” which can be as high as 7%.
- High fees. Annuities can charge as much as 3% a year, which is significant on its own. Still, there are also fees for withdrawing money, adding riders and administrative fees.
- Complicated terms. The benefits, exclusions, fee schedules, options and policies of an annuity can make choosing one very difficult. And if you don’t choose an annuity that works with your retirement goals, you could end up losing money on your investment.
- Taxed as income. If you set up your annuity as a pre-tax investment, your monthly annuity payments will be taxed as income. This means you’ll pay a much higher rate than with other investment income, which is traditionally taxed at the capital gains rate.
Are annuities worth it?
Whether it’s worth it for you to invest in an annuity depends on your retirement goals. If the stability of monthly payments and the security of investing with an insurance company is what you care most about, then an annuity may be a good option for you.
But if you’re looking to make a more straightforward investment to grow your wealth, the complicated terms and high fees of an annuity may not be worth it.
Compare alternatives to annuities
The security of an annuity can seem attractive at first glance, but like any insurance policy, it comes with complicated options, exclusions and fees. If you’re looking to invest, there may be better retirement fund options for you.
And if your goal is to leave a legacy for your spouse and heirs, compare annuities to other life insurance products to make sure you’re choosing the best policy for you.
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