When planning for retirement, one option for continued income is annuities. Many people shy away from annuity investments because they don’t fully understand how annuities work. However, annuities can be a consistent source of income for many during retirement with little or no risk involved. There are four different types of annuities that are available for investment.
As the name implies, this type of annuity provides income as soon as it is purchased. This type of annuity can be structured to allow for a monthly cash flow for a defined period of time such as 5 to 10 years, or it can provide income for the remainder of a person’s life.
For example, a person who is 65 and wants to retire immediately can draw their Social Security immediately or wait until age 70. If they wait 5 years, their Social Security benefit will increase by 32% of the present value. By purchasing a 5-year immediate annuity, income will be available for the interim while waiting for the social security benefits to reach the maximum payout.
Other options for an immediate annuity is to attach an “Inflation Rider” that increases withdrawal amounts annually or a provision that provides for a spouse if the annuity owner passes. With customizable options, immediate annuities are a safe and predictable way to guarantee retirement income.
For those who want to protect and preserve their principal amount for the future, but still want to earn interest on their money. With a higher yield rate than a typical bank Certificate of Deposit (CD) or savings account, a fixed annuity is a smart way to add money to a nest egg. In addition, if the structure is set up correctly, there are added tax benefits to this type of annuity. Once carried to term, a fixed annuity can be changed to an immediate annuity to provide retirement income.
Fixed annuities are a smart and safe way to increase savings that have not been collecting much interest in a typical CD or savings account. In fact, the average rate of return on a CD has fallen from 12.06% in July of 1984 to 0.86% in July of 2016! This type of annuity is appealing to many people because of the higher rate of return and the low risk involved.
Fixed Indexed Annuity
One of the most popular annuities, a fixed indexed annuity is designed with several features such as:
- A “lock and re-set” feature that guarantees to credit investment money with an interest rate that is based on the growth of stock market indexes such as the S&P 500, NASDAQ, or Dow Jones Industrials.
- If there are losses in the stock market, the investor does not need to worry.
- Additionally, earnings on this type of income are not immediately taxed.
- By using a crediting formula, a percentage of earning credit is determined and locked in even if the market falls eliminating the risk to investors.
The least appealing type of annuity is the variable annuity which is subject to market volatility. Not only can an investor lose the interest gained, but they can also lose part of their principal. This type of annuity is not a safe investment and therefore not advised.
Annuities may seem “too good to be true,” but for those looking for a particular type of guaranteed income, an annuity is an option that should be looked at carefully.
Downsides to Annuities
When used as a retirement planning tool, an annuity can be a safe and expected source of income. However, it is advised that research on individual annuities be conducted due to high fees or expenses connected with particular annuity packages. Finding the best annuity for a retiree’s particular situation with the lowest fees and expenses will yield the highest rate of return. Some items that can cut into earnings that investors should look out for include:
- Commissions – Since annuities are typically sold by insurance brokers, commission fees can be tacked on to the sale. Some commissions can be as steep as 10%, so be aware of the amount of fees a broker is charging. Finding an annuity with a low commission fee can save an investor thousands of dollars.
- Surrender Charges – A surrender charge is a fee for taking money out of an annuity within the first few years after purchase. Since the charge can be as steep as 20% if a person withdraws the money out after a year. So before purchasing an annuity, a buyer needs to evaluate their situation to make sure that they will not have a need for the money invested in an annuity.
- High Annual Fees – A variable annuity is not advised as a retirement tool due to the high annual expenses. Some typical fees associated with a variable annuity include an annual insurance charge, annual investment management fees, and various insurance rider fees, all of which can add up to 2% to 3% annually. This can take a large chunk out of a person’s retirement nest egg.
- Age – As with a 401(k) or IRA, it is not a good idea to withdraw money from an annuity until age 59 ½ due to a hefty 10% early withdrawal penalty.
Tax Benefits of Annuities
Just like the popular 401(k), annuity income grows tax-deferred until withdrawals are made. Then, the amount withdrawn is taxed at regular income tax rates. However, with careful planning, the amount of income tax paid can be significantly less after retirement compared to additional income received when working since even a small amount of extra income can push many people into a higher tax bracket.
No matter which type of annuity a person decides to invest their retirement nest egg, research and consultation with an experienced financial advisor will ultimately lead to a better choice for potential retirees. With the many different nuances involved in the many different types of annuities, knowledge can turn into an increase in returns and protection of retirement income.