Annuities: You’ve probably heard of them before and some of you might be quite familiar with annuities as a retirement income option.
Because they can be confusing and have many different options, it can help to have some information that simplifies the concept of an annuity.
First of all, what is an annuity?
An annuity is an insurance product you can purchase that may promise a certain level of income for life. Some reasons people purchase annuities are to generate lifetime income, grow tax-deferred retirement savings, and provide a legacy for their heirs.
How do annuities work?
You pay money into the insurance company, and in return you receive an income stream specified by the contract. Alternatively, you may elect not to take periodic income payments — enabling interest to accumulate within the annuity — and then withdraw a lump sum at the end of the contract period.
There are also tax benefits to an annuity. Money grows tax-deferred within the annuity, meaning you pay no tax on the earnings until you take them out. And unlike 401(k) plans and IRAs, there is no annual limit on the amount you can put in a non-qualified annuity.
What types of annuities are available?
There are several different types of annuities and a wide variety of riders you can add for different functions.
A fixed rate annuity has a stated rate of return and no loss of principal due to market downturns. A fixed indexed annuity has a rate of return that may be linked to an external market index (like the S&P 500), but still may offer a minimum rate of return and no loss of principal or interest credits if the market index declines. So, if the market index rises, interest is credited to the annuity.
A variable annuity offers a choice of investment sub-accounts, similar to the choices in a 401(k). This provides a chance to earn higher returns than a fixed annuity or fixed indexed annuity but with greater risks, including potential loss of principal. There are also choices based on when you want to start taking income from an annuity. Just as the name suggests, an immediate annuity starts paying you income very soon after you buy it.
A deferred annuity doesn’t start paying income until a point you designate in the future. In the meantime, your money earns a rate of return that’s rolled up, or added, to the account and income value within your annuity. In fact, you don’t ever have to take income out of the annuity, if you don’t need it. The money can keep growing, tax-deferred.
Now let’s look at caveats — the due diligence you need to do before making a financial commitment. Is it right for you? Annuities aren’t for everyone. You need to be certain an annuity is right for you, and after that which annuity is the right choice for your retirement needs.
One thing to be aware of is that annuities may charge fees in some instances. The fees can vary tremendously based on the kind of annuity you buy, the riders you add and the company offering it.
Another thing to understand is that annuities are a long-term commitment and they are primarily designed for retirement income. If you take an early withdrawal, you may incur a surrender charge. Additionally, if you take funds out before the age of 59½, there may be an additional 10 percent IRS penalty.
The insurance company, not the government, guarantees your annuity, so it is recommended that you check out their financial strength by going online to independent ratings agencies such as AM Best, Moody’s and Standard and Poor’s.
For some people, annuities can be a source of income in retirement. To determine if an annuity is right for you, it can help to contact a financial services professional.