Annuities are financial products that provide retirees with guaranteed income. How annuities work is through accumulating interest on the account, which is funded through a lump-sum payment or periodic payments. Upon reaching the annuitization phase, the investment begins paying out fixed-income payments to the retiree. Annuities come in many forms, giving investors more flexibility.
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UPDATED: Jun 29, 2022
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- Annuities are just one of many types of retirement planning vehicles
- Annuities provide retirees with lower returns but also substantially lower risk than other investments
- Through annuities, investors receive consistent payouts and budget for their retirement
- The structure of annuities varies between different types, allowing for investor creativity in their retirement plan
People rarely start planning for retirement soon enough. They may simply put it off or become overwhelmed with the options available.
Annuities provide investors with an opportunity to grow their retirement plan and budget for their monthly retirement expenses. Understanding how annuities work with the right insurance advice is the first step toward adding an annuity to your retirement plan.
Read our guide now to learn about annuities, how it works, and use our free legal search tool above to find a skilled annuity attorney in your area.
What is an annuity?
For many young people, retirement seems too far away to even worry about. But that kind of thinking could end up being detrimental to their long-term goals.
People closer to retirement age may also have concerns that they don’t have enough money to retire the way they envisioned. Maybe their investments have decreased during a market downturn, or they simply started their retirement funding too late and it hasn’t grown as much as they wanted.
Annuities can help with these kinds of issues. The definition of annuity is a contract between you and the insurance company. You agree to give them a certain amount of money, either in a lump sum or over time, and they agree to pay out monthly payments to you, either immediately or starting at a later date.
Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) regulate annuities. They were designed to create a reliable and steady cash flow for retired individuals.
To set up an annuity, you work with an insurance company. Many people take large lump sums from lottery winnings or a big inheritance and purchase an annuity. You can also create an annuity by making regular payments on a policy, like other insurance vehicles.
The income you get from the annuity payments is tax-deferred. This means you don’t pay any tax until you receive payments from the annuity. The payments are taxed at your regular income rate, not as capital gains.
It’s best to speak with a retirement or financial planning attorney to make sure your annuity fits nicely into your overall retirement plan.
Do annuities work like other retirement accounts?
Annuities are more of a complement to your overall investment and retirement strategy.
You may have retirement accounts through your employer, like a 401(k). You may have your own tax-deferred retirement accounts, like an Individual Retirement Account (IRA). You may even have a taxable investment account that you use to be more speculative. Annuities are just one more piece of this retirement plan.
While they may fit into your retirement strategy, they are not exactly like other retirement vehicles you may invest in for your future. In this way, annuities are essentially an insurance product.
You pay the insurance company a sum of money and they pay you back either in a lump sum or over time. The amount of the payment you receive back from the insurance company depends on many factors, like the type of annuity you choose and how much you paid to fund the annuity.
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How are annuities taxed?
A great way to ensure you have enough money in retirement is to hedge your investments. Taxes play an important role in that decision, and you need to know how your annuity is going to be taxed.
Unlike post-tax accounts like a Roth IRA, annuities are all tax-deferred.
Deferring taxes can be beneficial to your overall retirement strategy. First, the money goes into your annuity without the government taxing a single penny. That means you have more money in the account to grow.
Second, deferring taxes can reduce the amount of tax you may pay on that money. Because your income level in retirement may be lower than what it was when you put the money into the annuity, the income payments you receive will be taxed at a lower rate. So even though you have to pay taxes on the money, you will pay less in tax.
Do annuities have expensive fees?
Any time you make an investment decision, whether you are just starting your investing or you’re nearing retirement, you need to assess fees. The fees an insurance company will charge can vary, even among similar investments. These fees can eat into your profits, making some investments not worth your time or money.
Annuities are no different. Some fixed annuities do not charge annual fees, but nearly all variable annuities do. The variable annuity fees range from two to three percent. Be sure to closely review your annuity contract to know exactly what fees you’re going to pay.
There are other fees, as well, like commissions. These may be built into the policy and can range from one to 10%, depending on the insurance company and the type of annuity. Generally, the simpler the annuity, the lower the fees and commissions.
Ask your insurance agent about the fees. If they tell you the fees and commissions are built-in, it might be wise to walk away. What else are they trying to hide from you? You’ve worked hard for your money and you may have no problem paying fees, you simply want transparency. There are plenty of insurance companies offering annuities who will give that to you.
What are the different types of annuities?
There are two phases to your annuity:
- Accumulation: when you are making payments in your annuity
- Annuitization: when you start receiving payments back from the insurance company
Annuities can be structured in many different ways, and you have some autonomy over this decision. For example, you may choose to make a lump sum payment to open an annuity and then receive payments for the rest of your life.
You may also choose to receive payments for just ten years, regardless of how long you live. You can choose to have the payments start immediately or not for several years or at a certain age.
One important point to note is that when you fund an annuity, you’re taking liquid money and making it illiquid. Funding an annuity binds you, since it is a contract, to keep that money with the insurance company.
If you take money out of your annuity early or in a lump sum, you may be subject to fees and penalties. With this in mind, annuities are generally advisable only for people closer to or already in retirement.
What is the difference between immediate vs. deferred annuities?
Immediate annuities work as they sound — you buy an annuity from an insurance company with a lump sum payment and they immediately start making monthly payments to you. Immediate annuities can be both fixed and variable.
The best example of a person buying an immediate annuity is a lottery winner. Many lottery winners choose to take the lump sum payout instead of getting monthly payments from the lottery service. There are obvious tax implications to this but, if invested correctly, could leave the lottery winner with more money than if they took payments each month.
Then why would the lottery winner turn down monthly payments from the lottery service and turnaround and buy an annuity where they get monthly payments? It sounds odd, but the difference is in the return.
The lottery service won’t pay any interest on the monthly payments so the winner effectively gets less money year after year as inflation rises but the dollar amount of the payouts remains constant. An immediate annuity gives some return on that money, making it a smarter investment.
If you didn’t win the lottery, a deferred annuity may be the smarter investment for your retirement.
Instead of paying out money to you immediately, deferred annuities grow until the agreed-upon annuitization time period, either a set date or when you reach a specific age. This allows your money the chance to compound, potentially giving you higher returns. Like immediate annuities, deferred annuities can be either fixed or variable.
What is a fixed annuity?
A fixed annuity is a type of insurance contract you enter into with an insurance company, either on your own or through a broker.
You promise to pay the insurance company a set amount of money and the insurance company promises to provide a guaranteed interest rate on your annuity and give payments back to you at a set time.
During the accumulation phase of a fixed annuity, your account grows tax-deferred. When it’s time for the insurance company to start making payments to you per the contract, they will calculate the monthly payment based on the number of payments they are required to make to you, plus the current value of your account.
Once you start receiving payments in the annuitization phase, the money you receive will be taxed as regular income to you.
Pros and Cons of Fixed Annuities
One of the biggest benefits of a fixed annuity is predictable returns. When you sign the annuity contract with the insurance company, you will know the guaranteed rate the insurance company promises your account will receive.
Your annuity funds are also tax-deferred. Even though you pay income tax on the annuity payments you receive, you may be in a lower tax bracket, so you will end up paying less tax on this money than you otherwise would have.
Annuities also provide low-return but low-risk. As a complement to your overall investment and retirement strategy, a fixed annuity may help you add a chunk of change to your monthly retirement income.
However, annuities come with fees. Insurance companies may charge varying fees so it’s best to shop around for affordable fixed annuity rates.
Insurance companies will also charge fees if you take your money out early, sometimes as high as 10% of the account value. Make sure that an annuity is where you want to put your money.
Fixed annuities, while letting you plan by knowing exactly how much money you will get each month, rarely increase in value at the same rates as other investment tools. Even good return rates for fixed annuities don’t surpass 3%. A whole market index fund, for example, averages a return of more than double that, with not much additional risk.
Because fixed annuities depend on the strength of the insurance company and not the volatility of the market, choosing a strong company is just as important as the type of annuity. If the insurance company that holds your annuity folds, you risk losing your entire investment.
What are variable annuities?
Unlike fixed annuities that guarantee a rate of return, variable annuities hold sub-accounts, and the value of the annuity is determined based on the value of those sub-accounts.
These sub-accounts are made up of mutual funds so your return will depend on the mutual funds selected by your insurance company. Because variable annuities use mutual funds as the underlying investment tool, they are subject to the whims of the market. This is both good and bad.
In the short term, the market can be volatile. So variable annuities are recommended for long-term investors who can weather the volatility and see greater returns. And that’s the big upside when comparing variable annuities vs. fixed annuities: the potential for much larger returns.
Pros and Cons of Variable Annuities
As stated, variable annuities may produce higher returns than their fixed annuity siblings. Like a fixed annuity, variable annuities also grow tax-deferred. So you may be able to pay a lower tax rate on the annuity income you receive in the future.
With a variable annuity, your heirs may also receive a benefit. If you die before your annuity has fully paid out, your beneficiaries may receive a guaranteed death benefit. This can give you extra peace of mind that your family will be cared for in the event of your death.
The biggest downside to variable annuities is their risk. While they are not as risky as investing directly in the stock market, they do come with higher risk than fixed annuities.
Because the sub-accounts are invested in the market, even broadly, they are subject to market fluctuations. If you need the money soon, variable annuities might not be the best choice for you.
Variable annuities may also come with substantial management fees. You may be better off looking for other investment opportunities that charge lower fees but offer similar risks.
Who should consider variable annuities?
When planning for retirement, you have many investment options. All of the types of annuities discussed here are viable options for you, given the right circumstances.
Annuities are not right for every investor. If you have enough money set aside for retirement, you probably won’t need an annuity with fixed-income payments.
When considering an annuity, you first want to make sure you’ve maxed out your 401(k) and IRA contributions. These two retirement vehicles provide better opportunities without annuities’ fee structure.
If you have money that’s sitting and not growing, it’s a whise time to consider annuities as a serious part of your retirement strategy.
Putting your money to work for you is vital to your ability to save enough money in retirement. If you have substantial sums of money sitting in no-interest accounts, you’re effectively losing money to inflation. You need to get this money working for you. You can do that through an annuity.
You may want to speak with a financial planning lawyer in your area to help you understand all of your options and determine which annuity is best for your goals.
Every person has different needs and will have different goals. Some people may need an annuity to do some heavy lifting in their retirement because their other investments are lacking. For others, an annuity might be a nice way to add some money to your monthly retirement income.
Because there are so many options and so many tax implications, making this decision alone can be overwhelming. That’s why it is highly recommended that you seek out the guidance of a trusted financial planning attorney who can help you make the right choice for your overall retirement plan.
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What is the difference between annuities and life insurance?
Life insurance products offer people peace of mind that their families will not suffer financially in the event of an untimely death. Life insurance covers the family of the policyholder if that person dies prematurely.
When you get a life insurance policy, you pay monthly premiums and if you die early, the insurance company pays out a death benefit to your beneficiaries. In this way, life insurance deals with the risk of you dying sooner than you expect.
As life expectancy in the U.S. continues to grow, people need to prepare by having more money in retirement than what used to be required. For your family, you may decide to purchase a life insurance annuity. With annuity life insurance, your beneficiaries will receive their death benefits over time while the funds continue to grow interest.
Because many people are living longer, companies take on more risk with certain types of annuities insurance. To counter that, they may charge higher fees to consumers like you. You may want to speak with an experienced insurance lawyer before binding yourself to a particular insurance company or investment product to guarantee you’re getting the most affordable life insurance annuity rates.
Annuity Calculator Example
We’ve discussed at length what annuities are, how annuities work, the different options you have, and average annuity rates. Now let’s look at an example to try to put it all together.
Let’s say you’re looking to purchase a fixed immediate annuity. You’re in or just about to hit your retirement years and want to add to your monthly income with a low-risk option.
An insurance company might sell you a fixed immediate annuity for $100,000 paid by you in full. In return, the insurance company will pay you $1000 per month for ten years. This gives you a small but low-risk return on your money, adding to your monthly retirement funds. The exact amount of money you will receive each month will depend on your annuity contract with the insurance company, which will outline the interest rate they guarantee you.
How can I get more information on annuities?
Thinking about retirement can bring up both positive and negative emotions. You get excited about the freedom you’ll have to do what you want with those you love. You may dream of traveling the world or settling down in a peaceful beach town. Inevitably, your mind will also get anxious, wondering how you’re going to pay for all that fun.
Ensuring you will have enough money in retirement to do everything you dream about is stressful. It’s also extremely complicated. Even if you decide to use an annuity calculator and take the extremely simple investment route with a whole index fund and one bond fund, you still need to manually re-allocate those funds from time to time. Once you start putting more tools to work for you, it becomes even more complex and confusing.
To help you understand your retirement vehicle options, how annuities work, and how they may fit into your overall retirement strategy, use our free legal search tool below to find an affordable insurance attorney in your area.