Annuities 101: What They Are And Why You Should Consider One

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11 months ago

Annuities can be an exceptional retirement planning tool that offers guaranteed monthly payments and tax deferment advantages. Understanding the different types of annuities can help you choose the right one. This article will also review a few top reasons to consider purchasing an annuity.

What Is an Annuity?

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An annuity is a retirement planning vehicle that can provide guaranteed monthly payments for life. Annuities are contracts between you and an insurance company. Most annuities include two phases: accumulation and distribution. The accumulation phase is the period in which you make contributions to the premium. The distribution phase is when you begin receiving payments.

Reasons To Consider Purchasing an Annuity

Here are a few great reasons to consider purchasing an annuity:

Guaranteed Payments

If you choose a fixed annuity, you can enjoy guaranteed payments in retirement. Some variable annuities may also offer guaranteed payments, but your returns will vary depending on the market. Guaranteed income from an annuity can help many investors achieve their retirement goals. Choosing a deferred annuity allows you to plan for retirement with guaranteed payments, whereas an immediate annuity allows you to turn savings into reliable payments.

Lifetime Income

Some annuities issue monthly payments for life. An annuity with annuitization can help supplement retirement income or prevent you from running out of funds. While the returns you receive from an annuity may be less than other potentially riskier investments, like stocks, they do typically pay more than a savings account or certificates of deposit (CD).

Low-Risk Addition to Your Portfolio

When compared to other retirement planning tools, annuities are relatively low risk. Of course, your risk level depends on the annuity type you choose. Fixed annuities provide a guaranteed rate of return, making them less risky when compared to variable annuities. Adding an annuity to an investment portfolio that already includes riskier options can help diversify risk.

Deferred Taxes

Again, depending on your annuity type, you may benefit from deferred taxes. Deferred annuities allow you to defer tax liabilities until you withdraw the funds. Contributors currently in a high tax bracket may benefit most from this deferment, especially if you’re in a lower tax bracket once you retire. 

Whether you pay taxes on your initial contribution depends on if the annuity is qualified or nonqualified. Annuity contributions made using pretax money are qualified annuities, meaning you’ll owe taxes on the full amount. Any contributions you make to an annuity using already taxed dollars are nonqualified, meaning you’ll only owe on any earnings you receive.

Potential Cons of Purchasing an Annuity

Of course, it’s essential to be aware of the potential downsides of an annuity. Most annuities are subject to fees, including administrative costs and commissions. You may also be subject to tax penalties if you withdraw your funds before 59.5 years. Some annuity returns may depend on market performance, leading to some investors earning less than expected. Researching the different annuity types to choose the right one for your financial and retirement goals can help you offset the downsides of an annuity.

What Are the Different Types of Annuities?

The four primary types of annuities include:

  • Fixed: A fixed annuity provides a fixed rate of return. Your annuity contract includes a set interest rate that you’ll receive on your contribution, regardless of market performance.
  • Variable: A variable annuity provides a return based on market performance. Your return rate depends on how well your initial contribution performs when invested in specific mutual funds.
  • Deferred: A deferred annuity provides monthly payments later in life. With a deferred annuity, you can make monthly contribution payments during the accumulation phase.
  • Immediate: Immediate annuities offer guaranteed lifetime payments. In return for contributing a lump sum payment, you’ll receive consistent payments each month.

A deferred and immediate annuity can be either fixed or variable. Fixed and variable refer to the returns you receive with an annuity, whereas deferred and immediate determine when you begin receiving payments.

When to Purchase an Annuity

You can purchase an annuity in preparation for retirement or even after you retire. Purchasing an annuity before retirement may give you more time to earn returns or defer taxes. You’ll also have more time to contribute to the accumulation period with a deferred annuity. Some people may choose to contribute to an immediate annuity in retirement. This involves paying a lump sum in return for regular monthly income payments in the near future.

Investing for retirement may allow you to collect guaranteed monthly payments. Evaluating and comparing the different annuity types against your retirement goals can help you choose the right tools, ensuring you have the funds you need for a comfortable retirement.

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