What is an annuity & how can it help you prepare for retirement?
An annuity is a type of insurance contract in which you pay a series of premiums — or a single lump sum — and in exchange, you get a stream of income. You can customize the payout period of your annuity to match your needs. Often, annuities guarantee you income for life — and they can protect you from outliving your savings.
Annuities can help you manage your money so that you have a supplemental income in retirement. “Annuities are great fixed income vehicles,” says Jose V. Sanchez, a certified financial planner based in New Mexico, who specializes in retirement planning. “The right annuity in the right place is a very targeted tool for a portfolio.”
Learn more about how annuities work
What types of annuities can you add to your retirement plan?
Annuities are complex — there are many different types that can serve different purposes, depending on your financial needs. If you’re thinking about purchasing one, it’s important to have an understanding of the basic types of annuities and how they work.
Can you withdraw money from your annuity?
Immediate annuities
Immediate annuities are unique because you’ll begin to receive income payments right away — between 30 days and 12 months of purchase. You’ll fund an immediate annuity with a lump sum — which can be from a 401(k) plan, IRA, or the sale of an asset, for example. Your principal will gain interest based on the terms of the specific contract you choose.
Deferred annuities
Deferred annuities don’t start to pay out until at least a year has gone by — oftentimes, five to 10 years, or even longer. As you fund your annuity — during the so-called accumulation period — your funds will gain interest based on the parameters of your specific contract.
If you’re not looking to retire in the next year and you want to allow time for your principal to grow before annuitizing, or taking payments, a deferred annuity could work for you.
Learn more about the differences between immediate and deferred annuities
Fixed annuities
Fixed annuities can be either immediate or deferred. They’re called “fixed” because they offer you a fixed interest rate set by your insurer, and a guaranteed amount of income once you annuitize your contract.
Typically, fixed annuities will offer you a guaranteed minimum rate. The insurer sets a fixed rate for each rate period — usually a year — but it won’t dip below that minimum. Depending on the specific type of fixed annuity you own, you could also have a fixed interest rate for multiple years — like with a multi-year guaranteed annuity, or MYGA.
Fixed annuities are generally considered low-risk, so if you need a reliable way to earn modest returns in retirement, a fixed annuity could work.
Indexed annuities
Indexed annuities allow your funds to grow based on a market index. Indexed annuities are most often deferred, so if you need an income stream right away, they might not be the best fit for you. Indexed annuities typically expose you to some market risk, but they generally come with features that mitigate your losses up to a certain point. In turn, they also cap your earnings. [1]
Variable annuities
Variable annuities allow you more control over how your principal is invested. They also expose you to more market risk than other types of annuities because your funds can be invested directly in mutual funds, stocks, and bonds through subaccounts. Because of this, variable annuities are also considered securities, and they’re regulated by FINRA and the SEC. [2]
Most variable annuities are deferred, too, so like with indexed annuities, they’re best if you don’t need to start receiving payments right away.
Learn more about the difference between fixed annuities and variable annuities
Qualified annuities
A qualified annuity refers to any type of annuity contract funded with pre-tax (or qualified) dollars. This type of annuity is often set up alongside a 401(k) or 403(b) plan through an employer. Your funds will continue to gain interest tax-free, and when you start taking withdrawals, you’ll pay income tax on both the principal and interest earned.
You can withdraw money penalty-free from a qualified annuity as soon as you turn 59 ½, making them a popular option for retirees. [3]
Can you lose money in an annuity?
Non-qualified annuities
The term ‘non-qualified annuity’ refers to any annuity contract funded with pre-tax (or non-qualified) dollars. When you make withdrawals, you’ll only pay taxes on the interest earned, as opposed to both the principal and the interest.
Non-qualified annuities are often funded with savings or funds from other post-tax investment accounts. Like with qualified annuities, you’ll need to wait until age 59 ½ to withdraw funds penalty-free.
Learn more about other types of annuities
What are the benefits of adding an annuity to your retirement plan?
Annuities can “provide the flooring” for your retirement plan, explains Steven J. Lee, Ph.D., CFJ, and finance lecturer at Cal Poly Pomona. “Your annuity payout each month should equal your fixed retirement expenses…so you’re able to live somewhat comfortably and keep the lights on.”
Your discretionary expenses may change, but at least you’ll know the basics are covered. Plus, you can always plan for a higher amount of income in your installments depending on your financial situation.
Learn more about retirement annuities
Here’s a summary of some of the main advantages of annuities.
Guaranteed income
One of the biggest benefits of annuities is that they can guarantee you income for life. This way, you won’t run the risk of outliving your savings. In many cases, this guarantee still stands even if you were to run out of principal.
What is the impact of interest rate changes on your annuity?
Tax advantages
Annuities grow tax-deferred, so you won’t pay taxes on the interest you earn each year. You can plan for exactly when you’ll pay taxes and make withdrawals accordingly. This is especially beneficial if you’re using annuities for retirement, and you’re not making withdrawals before age 59 ½.
Payout flexibility
You can choose when you want to annuitize your contact, or start receiving payments. Most often, annuities guarantee you an income stream for life, but you can customize your contract to ensure you have the income when you’ll need it the most.
Learn more about life only vs. period certain annuities
Supplemental retirement income
Annuities can supplement other existing sources of income like Social Security or payments from a pension. You can use an annuity to cover your basic living expenses, so that your other sources can be used for discretionary funds.
Protection against inflation
Certain annuities can allow your money — and therefore your income payments — to gain interest with the stock market, which can help buffer against inflation. You can also add features like a cost of living adjustment rider to ensure that the payments you receive increase each year.
Are annuities a good investment?
What are the drawbacks of adding an annuity to your retirement plan?
Like any other financial product, annuities may not serve your needs depending on your financial goals. At the end of the day, “there’s no one horrible annuity and no one perfect annuity – and that goes for just about every possible tool or product in the industry,” Sanchez says. So it’s important to have a solid understanding of what you’re looking to accomplish before signing a contract.
Do annuities affect financial aid and other benefits?
Complexity
There are many different types of annuities and many ways you can customize your contract. It can be difficult to understand the nuances of your annuity — including interest rates, fees, and payment schedule — without the help of an advisor.
High fees & penalties
Some types of annuities — especially indexed or variable annuities — can have additional investment management and administrative fees that can detract from your earnings. Plus, if you need to withdraw funds before age 59 ½, you’ll incur an additional penalty tax.
Surrender charges
Most deferred annuities have some type of surrender charge, which is an additional fee you’ll pay if you withdraw funds from or surrender your contract within the first few years you own it. Surrender periods can last up to five to 10 years or longer — it depends on the insurer — so it’s important to be aware of the stipulations for your contract before buying and ensure your needs match up.
Loss of liquidity
Once you buy an annuity, your funds are no longer liquid, meaning you have to abide by the terms of your contract in order to access it.
Potential for lower returns
Depending on the type of annuity you choose, you could earn lower returns than you would with other investment vehicles — especially if you purchase a fixed annuity. However, this may align with your overall financial plan if you have other investment vehicles that are subject to more market volatility — it all depends on your personal situation.
Can annuities be used as a collateral for a loan?
How to add an annuity to your retirement plan
Retirement planning isn’t a one-size-fits-all endeavor — it’s important to have a solid understanding of your goals before moving forward with any financial product. Ask yourself, “what is it we’re solving for, and what are the tools and resources out there?” explains Sanchez. “Then, we can see what moves the needle in the right direction.”
Assess your income needs
If your main goal is setting up a supplemental income stream, determining when you need it and how much your regular living expenses are is an important step to take.
Select an annuity that complements your investment portfolio
Any annuity — or other financial product — you purchase should complement the rest of your financial plan and solve for a need. For instance, “if your goal is not guarantee but growth…and you’re young and you have time to outpace inflation…then annuities might not resonate with that,” Sanchez says.
Work with a financial advisor
Financial professionals can help walk you through the different tools available and the nuances of each contract.
“Having a professional really helps — whether [you’re considering] an annuity, a CD, a money market, or something more adventurous,” Sanchez says. In addition to product knowledge, “those certifications help because there’s education behind the logic” that helps consumers determine their needs.
