An annuity is a written agreement or contract between you and an insurance company in which you make a lump sum payment or series of payments. You will then obtain regular disbursements starting either immediately or at some point in the future in return. The main purpose of annuities is to provide a consistent stream of income when you retire. Just like 401(k) contributions, there’s no penalty if you withdraw the funds in annuity once you reach the age 59.5 and it accrues on a tax-deferred basis.
Types of Annuities
There are three types of annuities and each of them has their own level of risk and payout potential:
Fixed. The payout is guaranteed based on the balance of your account. The problem with this is the modest annual return that is generally higher than a CD.
Variable. Although variable annuity offers an opportunity of a higher return, it does accompany a greater risk. This leads to you picking from a menu of mutual funds that are composed of your personal “subaccount.” Whatever the performance of your investments in your subaccount is, your payments in retirement will depend on it.
Indexed. Contains a mixture of risk and potential reward because you can receive a guaranteed minimum payout but the portion of your disbursements depends on the performance of a market index such as the S&P 500.
Advantages of Annuity
1. Being able to sock away a large amount of cash and defer paying taxes is the biggest benefit you can get from annuities.
2. An annuity does not have an annual contribution limit compared to tax-deferred retirement accounts including 401 (k)s and IRAs. This means you will be able to put more money away for your retirement and those who are close to retirement age that needs to catch up will find this particularly useful.
3. You don’t have to worry about paying any tax bill from Uncle Sam because all the money you invest compounds year after year is tax-free.
4. You have the option to take a lump-sum payment from your annuity when you withdraw although a lot of retirees choose to set up guaranteed payments for a specific length of time of time or the rest of their lives. Therefore they can expect a steady stream of income.
5. The annuity complements other retirement income sources including Social Security and pension plans.
Disadvantages of Annuity
Most people think of annuities as a great money maker but they are often caught off guard by the hidden fees that can cut into any profits the annuity disburse. It is therefore important that you watch out for the following cons of annuities:
Commissions. Make sure you buy annuities that aren’t sold by insurance brokers or other salespeople who collect a commission of as much as 10% or else you’ll be paying more than what you’re supposed to.
Surrender Charges. In case you decide to pull out your money from an annuity within the first several years since you bought it, you will more likely get a prohibitive surrender charge because of it. Usually, the charge can reach up to 7% of your account value if you decide to leave after a year. The fee will then decline by one percentage point a year until it gets to zero after seven years or eight. There are even higher surrender charges from some annuities which are up to 20% in the first year.
Unreasonable high annual fees. Investing in a variable annuity means you will face high annual expenses. Expect to have an annual insurance charge that can reach up to 1.25% or more, fees on annual investment ranging anywhere from 0.5% to more than 2%, and fees for several insurance riders starting at 0.6% and up.
If you add them together, you may need to pay 2$ to 3% a year, worst, even more. That’s definitely a huge deduction from your retirement nest egg and may also affect the benefits you get of an annuity. Take a look at how a regular mutual fund charges an average 1.5% a year or index funds that charge less than 0.50% and find out which among them is better.
Withdrawal Penalty. You won’t be able to withdraw any money until you reach age 59 ½ because just like 401 (k) or IRA, the withdrawals you make prior to the mentioned age will require you to pay a hefty 10% early withdrawal penalty.
