If you’ve been preparing financially for retirement, it is likely that somewhere along the line, you have researched and/or been presented with an annuity. These financial vehicles are commonly used for accumulating money on a tax-deferred basis and/or for receiving income in retirement.
Annuities can come in a variety of different formats. So, even though they can provide a number of nice benefits, it is important that you have a good understanding of how they work before you move forward with purchasing one.
What are Annuities and How Do They Work?
Annuities represent a contract between you and an insurance company where, in return for one or more contributions, you can receive an income for a set period of time (such as 10 or 20 years), or even for the remainder of your life.
Depending on the type of annuity you have, you could also accumulate tax-deferred savings. This means that there is no tax due on the gain in the account until the time of withdrawal. This, in turn, can allow your funds to accumulate exponentially over time.
Important Annuity Terms
When learning about annuities, there are some common terms to be familiar with. These include:
- Immediate Annuity – Immediate annuities pay out an income immediately (usually within six months) in return for a lump sum contribution. Many people roll over retirement savings from a 401(k), IRA, or another account to an immediate annuity in order to generate income.
- Deferred Annuity – A deferred annuity pays out income at a time in the future (if at all). Before a deferred annuity is converted to income, the funds in the account grow tax-deferred.
- Accumulation Phase – The accumulation phase is the period of time before a deferred annuity is “annuitized,” or converted to income.
- Annuitant – The annuitant is the person upon whose life an annuity is based. He or she also is the recipient of the income from the annuity. (Sometimes the annuitant and the owner are the same, but they are not required to be).
- Owner – The owner is the individual who purchases the annuity. An annuity owner has the right to make changes to the contract, such as naming a new beneficiary.
- Beneficiary – A beneficiary can inherit an annuity contract if the annuitant passes away. In many cases, a death benefit is paid out to him or her if the annuitant dies before receiving back all of their contributions. Unlike a life insurance death benefit, though, there could be income taxes due on these funds.
Types of Annuities
There are many different types and categories of annuities available in the marketplace today. For example, an annuity can be either immediate or deferred. Annuities can also be fixed, indexed, or variable.
Fixed annuities promise a set, guaranteed interest rate on the contributions that go into the account. These financial vehicles are considered safe because there is no loss of principal, even if the stock market goes down.
In return for this safety, fixed annuity returns are usually quite low. These annuities can also pay out a fixed, ongoing income stream either for a certain period of time or for the annuitant’s lifetime.
Variable annuities have their return based on underlying equities – like mutual funds. These annuities provide the opportunity for a much higher return than fixed annuities. But because they are associated with market activity, there is also the chance of loss.
Fixed indexed annuities can provide a “best of all worlds” scenario. That’s because the return is based on the performance of an underlying market index, like the S&P 500. When the index performs well during a given contract year, the annuity is credited with a positive return – usually up to a specific cap, or maximum.
On the other hand, if the underlying index performs poorly, the annuity account does not incur a loss. Rather, it is credited with a set minimum “floor,” that is oftentimes in the range of 0% to 2%.
Fixed, indexed, and variable annuities allow for the tax-deferred build up of the funds inside the account. Each annuity type can also be converted to an income stream. Many annuities provide other benefits, too, such as a death benefit if the annuitant dies, and/or penalty-free withdrawals if the annuitant is diagnosed with a terminal illness and/or must reside in a nursing home for a specific time period, such as 90 days or more.
Pros and Cons of Annuities
Just like with any other type of investments, there are both pros and cons to consider with annuities. For example, some annuity advantages can include:
- Tax-deferred growth (and no annual maximum contribution limit)
- Income stream in retirement
- Death benefit/legacy for loved ones
There can also be some potential annuity drawbacks, such as:
- Fees (particularly on variable annuities)
- Surrender/early withdrawal charges
- Complexity/many “moving parts”
Should You Own an Annuity?
Although annuities can provide a lengthy list of benefits, these financial vehicles are not right for everyone. So, before you make a long-term commitment to purchase an annuity, it is recommended that you weigh out the positives with the potential drawbacks.
An annuity specialist can help you to determine whether an annuity fits in with your savings and/or income objectives – and if so, which type of annuity is right for you. At Annuity Gator, it is our mission to educate people on how annuities work, and whether or not they could be a good addition to your portfolio.
If you’d like to speak with an annuity expert, then feel free to contact us by phone at (888) 440-2468, or send us an email with your questions to our secure online contact form. We look forward to hearing from you.