An annuity is an investment alternative that can provide you with guaranteed monthly payments during your retirement years. You invest a certain amount of money with an insurance company or other financial institution, and in return you receive monthly payments for a specified term or the rest of your life, based on the investments the annuity company makes with your money.
You can make a lump sum payment to set up the annuity plan, such as when you receive an inheritance or take a lump sum payment from your 401(k) or other retirement account. Or, you can set up an annuity account in anticipation of your retirement and contribute to the account over an extended period of time to build up the balance on which your annuity payments will be based.
Types of Annuities
The two basic types of annuities are immediate and deferred. With an immediate annuity, you make a lump sum payment now and start receiving monthly annuity payments immediately. With a deferred annuity, you either make an upfront lump sum payment or make monthly payments until you decide to retire. The earnings in a deferred annuity account accumulate tax-free until you set up a schedule of lifetime payments that you typically start receiving once you retire.
In terms of the payments you will receive, you can set up a fixed annuity or a variable annuity. A fixed annuity invests your money in fixed-income funds, and you will receive the same amount each month, at a certain rate of interest that would generally be adjusted annually. With a variable annuity, you select from a list of mutual funds or index funds, where your money will be invested in equity securities and your future payments will depend on the funds' performance. In the variable-annuity scenario, you increase your risks, as well as your rewards.
You can choose the length of time you'll receive payments from the annuity: either a fixed term, the rest of your life, or for your lifetime and the lifetime of another person. You can also name a beneficiary who will receive the income if you die before a certain period of time elapses. Or, you can choose income for life with a refund payout to ensure that your beneficiary will continue to receive payments until the full value of the annuity contract has been paid.
Why Have an Annuity?
The main appeal of an annuity contract is that you are locking in a plan now to receive payments for the rest of your life, and potentially the life of your beneficiary. Your principal is protected if you choose a fixed annuity, and you don't have to be concerned with making decisions about where to invest your retirement savings. It will also be easier to budget during retirement if you know exactly how much is coming in each month.
The Ups and Downs of Annuities
One of the upsides to an annuity contract is that there are no contribution limits, as there are with IRAs or 401(k)s. You are not required to start receiving minimum required distributions when you reach age 70.5 as you would with an IRA. You can leave the money in your annuity account as long as you want, and earnings will continue to accumulate tax-free.
When you start receiving your annuity payments, you will be subject to income tax at the regular rates. If you're trying to figure out where you want to put any extra money, keep in mind that, if you put your retirement savings in a mutual fund, you could take advantage of the lower capital gains tax rates.
Another factor that might take a bite out of your annuity gains is high fees. Many annuities charge more for their services than many mutual funds. However, with research, you can find discount investment firms that offer no-load, low-cost annuity contracts.
Annuities may not be for you if you think you might need to take out money before retirement, as they have a surrender charge of around 7 percent. In addition, if you take withdrawals before you reach age 59.5, there is a 10 percent federal income tax penalty, plus ordinary income tax on the withdrawal. By the time you take the money out, you won't have much left. Therefore, you'll need to take stock of your financial past and future. For example, if you have a child about to go to college and there's a chance you might need that money to cover tuition costs, you might want to look at other options.
The type of annuity you choose also has its pros and cons. A fixed annuity gives you the security of a guaranteed monthly payment. The drawback is that your payments may not keep up with inflation. A variable annuity has a higher level of risk but can also generate a bigger return on your investment. The size of your monthly check will vary, but a good return on the fund investments could provide you with a better chance to beat inflation. On the other hand, the returns will also be subject to stock market conditions.
Before entering into an annuity contract, it is important to shop around, carefully review your options and ask questions to understand all the conditions and options. This way, you can determine whether an annuity is in your best interests, and, if so, which company and which annuity plan are right for you.
With equity-indexed annuities, you get returns based on either a minimum rate or a stock index, whichever is better at the time. That might sound like a dream, but strings are attached.
If you're evaluating annuity options and looking over annuity information, you'll run into information about the tax-sheltered annuity. What is a tax-sheltered annuity, and how does it compare with other annuity options?
If you're considering an annuity as a way to supplement retirement income, you must first know how do annuities work. In general, you would make a payment to an insurance company, and then the insurance company would make regular payments to you based on the terms of your contract.