You work hard and do your best to save for retirement. However, there are many factors you can’t control – like the ups and downs of the stock market, interest rates, and inflation. This uncertainty is one reason why annuities have become a popular option for retirement savings.
Although most people are familiar with the concept of annuities, they can still seem complicated and confusing. For one thing, there are several types of annuities. In addition, the benefits and terms can vary widely between contracts. This variety means it’s important to understand the differences if you are considering an annuity for your retirement income.
What Is an Annuity?
Insurance companies issue annuities as a form of insurance to provide a guaranteed monthly income stream for the life of the contract, regardless of market conditions. Annuities transfer the risk of losses from the investor to the insurance company.
You can customize annuities in a variety of ways, including according to how long you think you will live, when you want your payments to start, and whether you want to leave your income to a beneficiary after your death.
Types of Annuities
There are three main types of annuities, each of which offers different features and levels of risk.
- Fixed Annuity: A fixed annuity pays a guaranteed annual minimum income based on a fixed interest rate. These annuities are the safest option because what you will earn never changes. The downside of this predictability is the relatively modest rate of return.
- Variable Annuity: A variable annuity can hedge against inflation. There is no guaranteed fixed interest rate – your income payments depend on market performance. You choose from a selection of investments, typically mutual funds. The amount of money you receive is determined by the performance of these investments. There is a potential of higher returns, but the price of this is greater risk. If your investments do poorly and lose value, this could reduce future payments.
- Indexed Annuity: An indexed annuity falls somewhere between a fixed annuity and a variable annuity in terms of risk and reward. Indexed annuities are less risky than variable annuities but typically earn a higher interest rate than fixed annuities. Like a fixed annuity, an indexed annuity has a guaranteed interest rate. However, a portion of your return is tied to a market index, such as the S&P 500.
Immediate vs. Deferred
Annuities are also classified according to when the income payments begin. An immediate annuity is one you purchase with a single lump sum payment and provides income payments within one year of the purchase date. You can purchase deferred annuities with a lump sum payment or fund them incrementally through periodic payments. Deferred annuities allow you to delay receiving payments while the principal is earning interest.
Riders allow you to customize your annuity for an added cost. Some common riders include:
- Cost of Living Rider – Ensures your annuity payments keep up with inflation over time. You can pick the amount you want your annuities to grow by each year.
- Lifetime Income Rider – The insurance company will continue to pay you even if your annuity runs out of money.
- Impaired Risk – If you become seriously ill and have a decreased life expectancy, your annuity will increase in payment size to give you more money sooner.
- Death Benefit Rider – This is also known as a return of premium rider. If you die and have received less in payments than you paid into the annuity, your beneficiaries will receive at least as much as you paid into the contract.
Taxes, Fees, and Penalties
- Taxes – Annuities are often recommended for their tax-deferred growth potential. Your investment grows tax free for the length of the contract – you only owe taxes when you receive income payments. If you own a qualified annuity funded by pre-tax dollars, your distributions will be taxed as ordinary income.
- Fees and Commissions – These can vary widely depending on the type of annuity. You’ll pay a commission at the time of sale and may face maintenance and administrative fees for the life of the contract. These fees are usually deducted from your earnings. Check carefully to see if there are fees associated with your annuity – these will reduce your future payments.
- Early Withdrawal Penalty – Annuities are meant to be long-term investments. When you sign up, your contract will include a surrender period. If you take money before the end of the surrender period, you will be subjected to an early withdrawal penalty. Since annuities are not a liquid investment, you should avoid tying up all your money and only invest money you won’t need in the near future.
Free Look Period
Purchasing an annuity is a big decision. The free look period is a provision that allows buyers to change their mind and cancel their contracts with no surrender charges within a set time period. In the state of Texas, the free look period is 20 days for new contracts and 30 days for replacement policies.
Seek Guidance from a Trusted Professional
The overriding concern for many retirees is they’ll outlive their retirement funds. Most people want to grow their retirement savings in a way that protects their money from market volatility. However, an annuity isn’t right for everyone.
If you are interested in the benefits an annuity offers, it’s important to seek the guidance of a licensed financial professional. The team at PTT Financial can help you determine what type of annuity is right for you. We are here to help you achieve your financial goals. Contact us today.