Investing in an annuity can provide a steady source of income for the rest of a person’s life.
Determining how much money to save can be challenging when preparing for retirement. Even if you believe you have everything covered, it is difficult to predict how much you will spend or how long you will live once you retire.
Here, annuities come into play. These distinctive mixtures of insurance and investing characteristics assist individuals in saving for retirement and provide certainty that they will not outlive their hard-earned assets.
Learn more about annuities and if you should consider adding them to your investment portfolio.
How do annuities work?
Two phases comprise an annuity: the accumulation phase and the annuitization phase. Payments are made during the accumulation phase of an annuity. These monies may be allocated to numerous investment opportunities.
The annuitization phase is when you receive annuity benefits, similar to a normal wage. It could be for a certain number of years or for as long as you live. The distributions consist of both the principal and any investment profits.
Annuities offer reliable investing choices for individuals concerned about market volatility or outliving their retirement funds. There are three advantages associated with annuities.
Consistent revenue for a predetermined period. After making payments, your payments will continue for the rest of your life or your spouse’s life.
Additionally, you may specify a beneficiary for your annuity, and this beneficiary will get the payments in the event of your passing.
Before you receive payments, income from annuities and investment gains increases tax-free. Rob Williams, managing director of financial planning, retirement income, and asset management at Charles Schwab, explains: Annuities complement other retirement plans in that they offer growth prospects without significant taxes. You pay taxes on income from an annuity when you get payments.
Immediate and delayed annuity distributions
It is possible to purchase an annuity that pays out in the future or one that pays out immediately.
This is known as a single premium immediate annuity (SPIA). This option includes payouts beginning as soon as one month after purchase. Typically, it is acquired for a single lump payment. The insurance company then estimates the amount you owe based on your age, current interest rates, and the estimated duration of future payments.
You decide whether you want an income stream for a short time or life and whether you want monthly, quarterly or annual payouts. The amount you get throughout your contract is often fixed and guaranteed.
As implied by its name, the deferred payment annuity option waits for distributions to a future date. You can purchase a deferred plan with a one-time payment or make ongoing contributions to your account. After a certain period, typically many years, you opt for payments to commence.
The tax position is more convoluted, but the return of your principle – the money you first invested — is tax-free. You will only owe the IRS taxes on the annuity’s earnings during the deferred period.
In addition to your premium payments, you will likely incur other expenses. Annuity costs range between 0.5% and 3%. An annuity with higher-than-average costs may not be a wise investment since it might eat up a substantial portion of your earnings.
The mortality and expense risk fee compensates the issuer of an annuity for the risk it assumes by issuing the product. This fee is a proportion of your annual account value, typically approximately 1.25 percent.
The issuer charges administrative fees to cover the expense of maintaining records and managing your annuity. It may be a set yearly fee or a percentage of the account balance.
Commission fees contribute to the cost of an annuity and exist to compensate the individual who sold it to you. This may raise the price of an annuity. You may likely eliminate annuity commissions by purchasing from a fee-only advisor who is expected to operate in your best interests as a fiduciary and is compensated solely by you.
Fund expenditures are the charges associated with the funds, such as mutual funds, that your annuity may invest in. Annuity features, such as a guaranteed minimum income benefit or long-term care insurance, incur additional feature costs.
You will incur penalties if you remove from an annuity before age 59.5. In addition to usual income taxes owed on the withdrawal amount, the Internal Revenue Service will assess a 10% tax penalty.
Surrender costs apply to variable annuities when money is sold or withdrawn within the surrender period, typically six to eight years following the annuity’s purchase. Early withdrawals may result in unforeseen tax consequences, making variable annuities superior for long-term objectives.
With so many various expenses, you should ensure you can afford an annuity before signing the contract. You must also ensure that the benefits surpass the expenses.
Advantages and disadvantages of annuities
Annuities are fundamentally advantageous:
Regular payments give you a source of guaranteed income during your retirement. Low-risk rewards. Unless you have a variable annuity, annuities are typically a more secure investment. Tax-deferred expansion. The growth of your annuity’s earnings is exempt from taxation.
Unfortunately, there are also significant negatives to consider: Big fees. The hefty fees and commissions associated with annuities can significantly reduce their long-term earning potential. Due to this, annuities are not a fantastic location to build your money, but fixed instant annuities incur lower fees while providing a lifelong income.
Variable annuities provide access to funds only after some time, often six to eight years but sometimes more. Suppose you withdraw money or cancel your annuity contract before the end of the surrender term. In that case, you will be charged a surrender cost of up to 10% of your initial contributions, falling by one percentage point yearly. Once your payments begin, it is very hard to alter them or have access to additional capital.
Income is subject to tax and tax penalties, and annuities are not entirely tax-exempt. Annuity payments are liable to income tax as they are received. If you withdraw your annuity before the age of 59 1/2, you will be subject to a 10% penalty in addition to your regular income tax.
The financial benefit
Annuities complement your retirement savings plan, provided you consistently contribute the maximum to your 401(k) and can pay the costs. They give you a stable income during your retirement, grow tax-free, and can benefit your beneficiaries as well.
Because annuities are not free, you must compare their expenses against their claimed advantages to determine whether they are the best option for you.