Depending on where you’ve been spending your time online, you may have heard how great and wonderful annuities can be. You may also have seen warnings about how terrible these products are, especially given their surrender periods and fees.
In essence, both of these positions can be right – depending on what your specific needs and financial objectives are. That’s why, before you move forward with the purchase of an annuity (or for that matter, with any financial product), it is important that you ask the right questions. That way, you will be in a much better position to make a decision regarding whether or not the product is right for you.
Here are the top five questions that you need to ask before you make a commitment to an annuity:
1. How do annuities work?
First and foremost, how the heck do these products work?
There are actually several different types of annuities – and each can work a bit different. For instance, fixed annuities offer protection of principal, a guaranteed interest rate, and a fixed amount of income when you need it. This is typically in exchange for a lower rate of return. Alternatively, variable annuities offer the opportunity to obtain a higher, market-like return. But given their exposure to the market, you can also run into more risk with a variable annuity.
A fixed index annuity offers a way to attain an index-linked return. This means that the return is based – at least in large part – on how an underlying index, such as the S&P 500, performs. With this type of annuity product, your upward return is oftentimes “capped.” However, if the tracked index performs poorly during a given period, your annuity is not hit with a negative return. Rather, it is simply credited with 0% for that time period.
Regardless of the type of annuity you go with (i.e. fixed, fixed index, or variable), the growth that takes place inside of the annuity will be tax-deferred. This means that you will not owe tax on any of the gain until the time of withdrawal.
All annuities offer the option of receiving a set amount of income for a certain period of time. If you choose the lifetime income option, you can count on receiving income for the remainder of your lifetime – no matter how long that may be. This, in turn, can help to alleviate the worry about running out of income in the future.
2. What types of fees are charged on annuities?
Similar to other financial vehicles, you may typically run into at least some charges or fees when you own an annuity. Depending on the type of annuity you have, some of the most common fees can include:
- Mortality & Expense (M&E) fees – These fees can run, on average, 1.35% per year. They help the insurer to pay for the insurance guarantees that are included with the annuity.
- Administrative fees – Administrative fees go towards paying for marketing and other costs of keeping the annuity in force. These fees generally run between 0.10% to 0.30% per year.
- Commission – In some cases, there will be an up-front commission paid to the agent who sold you the annuity.
- Rider fees – If you choose to add an additional rider to the annuity, you may be charged more premium for these added benefits.
- Investment management fees – If you own a variable annuity, then you will also likely run into fees that are charged for the underlying funds that the annuity is tracking.
- Surrender charge – Most annuities will impose a surrender period, during which time if you cash out of the annuity (or if you take out more than a stated, penalty-free amount), you will be hit with a withdrawal fee. The amount of the surrender charge on an annuity will usually be reduced over time until it eventually disappears.
3. How are annuities taxed?
Annuities can offer a number of nice tax advantages. First, during the “accumulation” phase (i.e., the time that your money is in the account before it is converted to an income stream), the growth of your funds is tax-deferred. This means that no tax is due on the gain until you withdraw it.
When you receive income from an annuity, the tax treatment depends on how that annuity was purchased. For instance, if you contributed pre-tax dollars (such as funds from a traditional IRA or 401k plan), then 100% of your income from the annuity will be considered taxable income.
On the other hand, if you contributed after-tax dollars into the annuity, a portion of each income payment will be taxed (the portion that is considered to be gain), and a portion that is considered a return of your principal will be tax-free.
4. Is annuity income really guaranteed?
Most annuities offer several different options when it comes to generating an income stream. But regardless of which income alternative you opt for (if any), know that the income is guaranteed, based on the contract that you have with the underlying insurance carrier.
That being said, an annuity’s income guarantee will ultimately be dependent upon the financial strength of the insurance company that offers it. The good news is that insurance companies are highly regulated – and with that, they have strict requirements as to their own investments, as well as their capital reserve. One of the best ways that you can check on an insurer’s financial strength and stability is to review the ratings that are given to it by A.M. Best, Standard & Poor’s, Moody’s, and/or Fitch.
On top of that, given the (unlikely) scenario that an insurer would go under, every U.S. state has a Guaranty Association that helps to protect consumers if an insurance company is unable to pay its obligations.
5. Is an annuity right for me?
Because all financial situations, goals, and objectives are different, annuities can be an ideal solution for some people but a bad idea for others. However, if you are seeking a way to ensure that you’ll have a guaranteed income stream in retirement, then an annuity could certainly be worth a look.
Plus, in addition to just using an annuity for income purposes, there are actually other ways that these financial vehicles may be beneficial as well. For instance, many of today’s annuities offer features like a death benefit and penalty-free access to funds for nursing home or terminal illness costs.
Before you make a commitment, though, be careful. Choosing an annuity based on the presentation of an insurance or financial salesperson may work out in their best interest, but not necessarily yours.
For that reason, it is much more advantageous to find an unbiased annuity source that can help you with reviewing annuities in general, as well as comparing those that may best fit your specific needs.
That’s where the Annuity Gator comes in!
We have been providing in-depth annuity education to consumers for many years. We aren’t tied to one single insurance company, so we won’t try to fit square pegs into round holes when it comes to fitting a product to your needs.
Want more info on whether or not an annuity may be right for you?
Just reach out to us using our secure contact form and we’ll be happy to help.