When saving for retirement, there are a handful of options. However, when considering options, many worry about an income stream during retirement. Thankfully, an annuity addresses the income stream issue, but it sparks the question, what is an annuity, and how do I choose one? In this article, we’ll give you a quick 101 Guide for Non-biased consumers.
What is an Annuity?
An annuity essentially guarantees an income for an extended period of time. They are contracts that are distributed or sold from some sort of financial institution, where the funds you pay are invested.
They’re primarily used for those in retirement because they help people decrease the risk of outliving their savings. Basically, you pay a certain amount upfront, and the company will pay you back every month. These contracts will set the age at which payments start, payment intervals, and other details.
What are the different types of annuities?
These are pretty simple. A fixed annuity provides regular periodic payments to those who signed the contract. Fixed annuities will guarantee an investor a fixed return on their investment. They offer a fixed rate of return for the time period of the contract.
These are great because they make for easy budgeting, give a sense of control and clarity, and guarantee a return. However, while these are great, they do offer limited returns, some fees and could expose you to inflation.
With a variable annuity, your balance and payments are contingent upon the performance of the market. It’s easy to compare a variable annuity to an individual retirement account (IRA). They’re both retirement savings accounts that offer tax-deferred growth for investing. However, you’ll have to pay income taxes at your marginal rate when you start receiving payments.
One difference, though, is that variable annuities will let you make unlimited annual contributions to a tax-advantaged account. This is different from IRAs and 401ks because they have contribution limits.
Variable annuities are great because it gives you a solid lifetime income, maximizes tax benefits, and could increase future payments to you. However, this does come with some risks. There are relatively high fees in the contracts, and the returns are unpredictable. At the same time, you have to pay a surrender fee if you need to tap into your annuity fund.
An immediate annuity is the most basic type. You just make one large contribution upfront. That payment is then converted into a guaranteed stream of income for a specific period of time. Immediate annuities can cover your entire lifetime.
You can receive payments immediately or defer for a year. These annuities typically last from five years to an entire lifetime. Some tax advantages come along, as your income is partially tax-free. Having a consistent, fixed income can be the right option for those that want to play it safe.
Lastly, you may have options for added protection, like the cost of living adjustment to protect you against inflation. There’s also a liquidity feature, which allows you to take funds out of the accounts. However, just know that not all firms will offer these features. This is not best if you already have enough income or don’t have tons of retirement savings.
A deferred annuity is very similar to an immediate annuity. The buyer sets the future date for the payments to begin. Deferred payments are nice because it allows the money in the account more time to grow.
Also, much like a 401k or an IRA, the annuity continues to increase earnings tax-free until the money is withdrawn. That means that for you, it could build up to a larger sum leading to larger payments for you. Deferred annuities can still be fixed or variable.
An equity-indexed annuity is a fixed annuity where the rate of interest is linked to a particular index, like the S&P 500. The insurance company will set the rate of growth of the contract. Equity-indexed annuities are complicated, as insurers will use various methods to calculate the index return.
You won’t really know how much you’ll get back, but the calculations should give you a general idea of what the return will be like. Also, equity-indexed annuities usually don’t include reinvested dividends when calculating index returns, and often carry high surrender charges.
Which one is right for me?
Short answer: it depends. It depends on when you want your payments, how much assurance and guarantee you won’t, and how much risk you’re willing to take. The majority of people seeking one will generally go with immediate annuities. If your first concern is having an income stream you can’t outlive, an immediate annuity may be the best option for you.
If you’re more of a planner and like to prepare ahead, deferred annuities may be best for you. Of course, you’ll have to set up the account prior to actually getting the payments, although you’ll have peace of mind. Immediate, deferred, and fixed annuities will be best for those wanting to play it safe.
If you’re willing to play the game and risk some volatility, the variable annuity may be best for you. Lastly, fixed index annuities are best for those who have time before really needing income. Fixed index annuities allow for better opportunities for higher profits, but without the inherent risk. If you can plan early, fixed index annuities would be best for you.
At the end of the day, it depends on your needs and situation. If you’re shooting to play it safe, go with immediate, deferred, fixed, and fixed index annuities. If you are willing to take some risk, go with the variable annuities.
When Not to Buy an Annuity
Annuities aren’t suitable for everyone. If you have something to cover your retirement already, there’s no need to get one. You also shouldn’t buy one if social security or other pension benefits are going to cover all of your regular expenses. If you’re seeking high returns, this may not be best for you.