You probably already have an opinion on annuities. Maybe you are firm for or against them. However, it's also very likely that you don't know much about them and want to find out more.
An annuity is a contract between you and an insurance company. You finance your annuities with either lump sums of money or increments over time. In return for your payment, the insurer will provide you with a future payment (with interest) or a guaranteed income stream that you can start collecting immediately or later.
Annuities have a design in an investment account, but they are not suitable for everyone. Here are four advantages and disadvantages of annuities to help you decide if you might benefit from purchasing an annuity.
Fixed annuities offer high rates but have some advantages.
A fixed annuity is simple. The amount of revenue you receive is based on a predetermined rate which is usually a term. It can provide diversification outside your bond portfolio or, if you are frustrated with the low rates offered by CDs, it will usually pay a higher rate. For example, if you buy a five-year CD, you can expect to earn 1% on average, but if you use the same money to buy a fixed annuity, you can earn up to 3%.
In general, fixed investment does not adjust well to inflation. You feel comfortable knowing exactly what to expect, but you may find it difficult to meet your living expenses each year. With fixed products, you are also subject to their commissions, and if they increase, you may not always be able to take advantage of them. In addition, annuities have very little flexibility, and if you sell the annuity before the end of the holding period, you will have to pay a fee called a surrender charge, which depending on the length of your term, can be very high.
If you favor predictability over flexibility, a fixed annuity can add value to your portfolio; however, if you have short-term liquidity needs, limits on accessing your money would make this type of investment less suitable.
Variable annuities provide exposure to the market but generally have high costs.
Variable annuities help your income keep up with inflation better than fixed annuities. However, they are a bit more complicated, and their income is usually tied to the value of the funds in which they are invested. Nevertheless, if it works well, your income will increase.
For example, suppose you buy a variable annuity for $50,000 and the year of your retirement doubles to $100,000. In that case, the withdrawal rate is now based on the highest value in your account. The insurance company you buy your annuity may also offer you some minimum income guarantee if the markets don't perform well and your account doesn't grow. If, on the other hand, your pension is reduced to $25,000 when you retire, the insurer will usually offer you some minimum rate that you can trust.
This type of benefit makes a variable annuity more expensive than a regular investment account, and additional fees can reduce the return on investment. The value of your account is also reduced by the withdrawals made, and if the percentage of withdrawal you receive exceeds the growth rate of your account, your account will be emptied. You can still depend on income, not your capital.
A variable annuity will provide you with income, but if maintaining your wealth is so important to you, you might be frustrated with this type of investment. Also, if you are familiar with commissions, this type of investment is not for you.
Annuities are tax-deferred, but there is no early deduction or tax-exempt growth.
If you pay a lot of taxes, you can use an annuity to create a tax-deferred investment and reduce your debt. If you add non-retirement money to an annuity, any contributions you make, as well as any interest or dividends you put into your account, will increase the deferred tax.
Although your investment grows with the tax-deferred, it pays taxes when you start making withdrawals. Therefore, the rate at which you pay taxes if you have funded your pension in after-tax dollars will take into account the portion of your pension that comes from your wealth (on which you have already paid taxes) and the portion attributed to the increase (which you don't pay tax on).
The tax deferral benefit comes at a cost, and when you start an annuity, you are subject to the same tax penalties as retirement money. If you withdraw your membership fees before you turn 59½, you incur a 10% penalty for any portion of the tax plus tax withdrawals. This places limits on your taxable money that you wouldn't have in a regular brokerage account, and if you are considering an annuity for this purpose, you need to remember this limit and carefully weigh the benefits.
You can fund your annuity with retirement money. But if so, tax benefits shouldn't be your primary focus, as these accounts already have the benefit of tax deferral. A good reason to buy an annuity with a 401(k) or an IRA is the income stream. Since most employers no longer offer pensions, you can create your own retirement-like investment with an annuity.
Bottom Line
Annuities have good and bad qualities and are not suitable for everyone. Deciding if an annuity is right for you requires educating yourself and considering your needs. If the advantages they offer match your needs and outweigh the disadvantages, annuities can be a very important part of your investment plan.
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