Pew Research Center estimates that over 10,000 Baby Boomers cross the retirement threshold each day.
Of all the concerns, one continues to top the list:
How can I make my money last through retirement?
It’s easy to understand why there is so much anxiety about the idea of running out of money:
- For most private-sector employees, defined benefit plans are a thing of the past,
- Media outlets continue to report that Social Security is running dry, and
- Between inflation, inadequate financial planning, and unanticipated healthcare costs, it can feel near impossible to find reliable, low-risk income streams to support your dream retirement plans!
With every new story of a retirement plan gone wrong, the safety of guaranteed streams looks ever more attractive. Annuities can provide just that.
Annuities offer protected lifetime income that you won’t outlive.
By investing in annuities, you’re also investing in a stable and predictable source of income, tax relief, asset protection, and peace of mind.
However, as with any investment vehicle, annuities aren’t right for just anyone. If you’re exploring annuities as a long-term investment option, here’s what you need to know.
What is an annuity?
An annuity is a long-term investment designed to provide you with a guaranteed steady income in retirement. In addition, annuities offer another tax-sheltered retirement savings option if you’ve already maxed out your 401(k) and IRA. Aside from qualified longevity contracts (QLACs), annuities have no contribution limits, so you can save to your heart’s content.
Annuities are one of the most flexible savings vehicles today.
Annuities come in all shapes and sizes:
- You can buy an annuity by making either a single payment or a series of payments.
- Similarly, your payout may come either as a lump-sum payment or as a series of monthly, quarterly, or annual payments.
- You can choose to receive your payments immediately, or you can defer the date of payment.
- You can select between a fixed, variable, or indexed rate of return.
How do annuities work?
An annuity works by transferring risk from you, the owner, to the insurance company. You make payments to an insurance company that invests your funds, and upon your retirement, the insurance company will issue a stream of payments that can last for life.
In contrast to other types of insurance, you’ll only pay your annuity premiums for a set period of time during the accumulation phase.
Later down the road, you’ll cross into the distribution phase, when you stop paying your premium and the annuity starts paying you.
Enjoy guaranteed income for life
Annuities allow you to generate a retirement cash flow that isn’t vulnerable to market ups and downs.
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There are many types of annuities, and they all offer some form of income stream protection. From there, annuities come in different variations. Each type has unique features that can help you achieve your financial goals whether you’re saving for retirement, approaching retirement, or already retired.
In this article, we’ll discuss 5 major types of annuities:
- Fixed Annuities
- Variable Annuities
- Fixed-Indexed Annuities
- Immediate Annuities
- Deferred Annuities
Types of Annuities
Annuities can be structured according to a wide array of factors.
Three common types of annuities are Fixed, Variable, and Fixed-Indexed.
Annuities can be Immediate or Deferred, in terms of when they begin to make payments.
With a Fixed Annuity, your insurance company will provide a fixed amount of periodic payments and a minimum rate of interest, typically higher than a CD or bond. You can either defer income or you can immediately draw income. They’re one of the less popular annuities because there is no upside than the stated interest payment.
In order to deliver your return, the life insurance company invests money in low-risk vehicles like highly rated corporate bonds and U.S. Treasury securities. They’re safe and predictable and can be a good fit if you have a low tolerance for risk and don’t mind receiving modest returns.
Fixed Annuities are regulated by state insurance departments.
Not all annuities guarantee a fixed rate of return. With a Variable Annuity, you can direct your payments to different subaccounts, similar to mutual funds. Some companies offer blended portfolios, while others offer 30-100 individual investment options and free movement between those options. You choose where your premiums are placed, and thus the overall returns on your annuity.
Variable Annuities are the most popular form of annuities partly because of the opportunity for higher returns as compared to a Fixed Annuity. Your payout will vary depending on how much you put in, the performance of these subaccounts, and management fees.
Another great benefit is the guaranteed flow of income for your lifetime or up to 20 years, whichever is longer — this becomes a great tool for income planning for you and your next generation. Since all proceeds grow tax-deferred, Variable Annuities can be used for Estate Planning for future generations of tax-deferred income.
Variable Annuities also lock in your initial deposit as the minimum amount that your account will be worth using one of their Riders. Some Riders offer a minimum guarantee that your account will increase every year, should this money be used for a future payout. In a bear market, these Lock-In Riders may be the difference between losing money in a brokerage account and receiving a minimum guaranteed amount for future payouts!
The insurance company doesn’t guarantee Variable Annuity rates, so as the annuitant, you bear the investment risk. The upside is that you have a lot of control—you can participate in the stock market and still enjoy the tax-deferred, insurance, and lifetime income benefits of annuities.
Variable Annuities are regulated by the SEC.
A Fixed-Indexed Annuity (FIA) offers the opportunity for tax-deferred growth that’s based partially on changes in a market index, plus the option to convert your annuity into a guaranteed retirement income stream.
It’s important to clarify that your crediting strategy tracks the stock market, but your money is never actually in the stock market. Rather than directly investing in the equity or bond markets, you can invest in one of the several Indexes. Most of them have a minimum floor that you can lose–often no more than 0 percent for the period of point-to-point, which refers to the date of your contract and one year from this date.
FIAs can use many different and blended Indexes. In a bull market, FIAs can underperform a Variable Annuity. In a bear market, FIAs can outperform Variable Annuities because of their floors.
FIAs are a good option if you want the opportunity to earn indexed interest while protecting your principal from market losses. They combine the low-risk nature of a Fixed Annuity with the potential capped returns of a Variable Annuity.
Immediate vs. Deferred Annuities
As its name implies, an Immediate Annuity is structured to begin paying income almost immediately upon deposit of a lump sum.
The insurance company begins paying you an income one annuity period after purchase, which can be 30 days to one year. Because payments begin so soon, Immediate Annuities are popular among retirees.
After paying the initial premium, you can receive regular income, which can be deferred up to one year. The remaining funds accumulate on a tax-deferred basis.
Deferred Annuities don’t begin paying out immediately after your initial investment. Instead, you can specify the age at which you’d like to begin receiving annuity payments. Your payout period can be years or decades into the future. That’s why they’re great supplements to 401(k)s and IRAs.
In the accumulation phase, your account grows tax-deferred.
After your final premium has been paid, your account has reached the distribution phase, and it begins making regular payments to you.
One of the best benefits is that most Deferred Annuities have no IRS contribution limits. Your premiums grow tax-deferred inside the annuity. The earnings credited to your contract are taxed when they’re withdrawn.
Are you at risk of outliving your savings?
Whatever your financial and life goals, we can help you find an annuity that offers tax-deferred savings for your retirement, asset protection, or income generation.
Get in touch for a complimentary consultation with a Fiduciary Financial Advisor today!
Adding Riders for Additional Benefits
What are Contract Riders?
You can augment your annuity with optional Contract Riders to accomplish various goals. Riders enhance income, legacy, and long-term care provisions.
Types of Riders
Living Riders provide benefits while you’re alive.
Death Benefit Riders
Death Benefit Riders protect your beneficiaries against a decline in the annuity’s value.
Common Annuity Riders
An Income Rider attached to a Deferred Annuity allows you to access your lifetime income stream whenever you want, as opposed to the age that you specified when signing your contract. This gives you the freedom to make that choice at a later date if your financial conditions change.
Guaranteed Minimum Death Benefit
The Guaranteed Minimum Death Benefit guarantees that if you die before your annuity starts paying out, your beneficiary will receive the greater value between the current value of the annuity or the total premiums paid.
All riders come with an additional fee that’s charged for the life of the policy.
Cost of Living (COLA) Rider
A COLA rider provides for increases in the monthly payments, based on a measure of inflation. Your benefit payments can increase based on the Consumer Price Index (CPI), provided by the Bureau of Labor Statistics or as a level percentage increase.
How Annuities are Taxed
The way your annuity is taxed depends on whether it’s a Qualified Annuity, funded with pre-tax dollars or a Non-qualified Annuity, funded with after-tax dollars.
When funding your annuity with pre-tax dollars, all withdrawals will be taxed at your ordinary income rates.
When funding your annuity with after-tax dollars, only your earnings will be taxed—you won’t be taxed on the portion of your withdrawal that represents a return of your original principal.
If you choose to withdraw before age 59½, you may be subject to a 10 percent IRS penalty.
Pros and Cons of Annuities
Annuities come with unique advantages that can’t be found in any other investment. However, it’s important to assess the disadvantages to weigh whether annuities are right for your retirement portfolio.
- Investment earnings grow tax-free. That means your money can grow and compound faster than money in a taxable account earning the same before-tax rate. The higher your tax bracket and the longer you defer, the bigger your advantage. While you’ll eventually have to pay taxes on your earnings, you’re likely to do so at a lower income tax rate in retirement. You’ll also have the option to control your withdrawals so that more is taken during years of lower tax obligation, and vice versa.
- Alternative to other tax-favored investments. If you’ve exhausted other forms of tax-favored retirement savings, like 401(k)s and IRAs, annuities offer yet another tax-advantaged investment option. As your earnings compound over time, you’ll have growth potential that’s unmatched by taxable accounts.
- Unlimited contributions. Deferred Annuities have no IRS contribution limits, so you can invest as much as you want for retirement. This helps you catch up on retirement savings when you have less time to save.
- No required minimum distributions (RMDs). Unlike qualified retirement plans requiring you to withdraw from your account by age 70½, certain annuities may not have RMDs. You can continue to defer taxes as long as you’d like.
- Competitive interest rates. The rate paid by Fixed Annuities is based on yields generated from your insurance company’s own investment portfolio, which tends to be higher than similar investment vehicles such as money market accounts or CDs.
- Minimum rate guarantees. Your initial interest rate guarantee will expire, after which your rate will be adjusted to current market rates. Current market rates could be higher or lower, but never lower than the minimum rate stated in your contract.
- Safety of principal. With Fixed Annuities, your principal balance is backed by your life insurance company’s assets. States impose stringent reserve requirements, and the highest-rated life insurers are generally recognized to be the safest of all the financial institutions. Moreover, most states have a guaranty fund to cover any annuity losses.
- Access to funds. You can withdraw up to 10 percent of your account balance annually before accruing any charges. After the surrender period, which lasts as long as 12 to 15 years, you’ll have access to 100 percent of your money.
- Reduced tax impact on your Social Security benefit. If your total income from all sources surpasses a specific threshold ($34,000 for individual filers and $44,000 for joint filers), up to 85 percent of your benefits may be taxable. Annuity income is exempt from this calculation.
- Asset protection. Annuities are one of the few investments with almost complete protection from creditors and lawsuits. The provisions vary by state.
- Probate protection. By designating a beneficiary in an annuity contract, owners protect heirs from probate. Your annuity proceeds are protected from the delays and expenses associated with the probate process.
- Death benefits. If you pass away before your distribution period begins, your beneficiary receives at least the amount that you put in. Many annuities also offer an “enhanced” death benefit.
- Illiquidity. Deposits into annuities are generally locked up throughout the duration of the surrender period, which usually lasts from two years to 10 or more. Consider your financial requirements during the duration of the surrender period, and ask your Fiduciary Advisor whether you have sufficient liquid assets elsewhere in your portfolio prior to purchasing an annuity.
- Surrender fees. You must pay fees on withdrawals exceeding 10 percent of either original premium deposit or 10 percent of your account value. Surrender fees start out at around 7 to 15 percent and decline by a percentage point each year until they vanish at the end of the surrender period.
- Early withdrawal penalties. For the privilege of deferring taxes on earnings inside an annuity, you will owe a tax penalty on any withdrawals made prior to age 59½.
- Fees and expenses. Annuities are a controversial topic in retirement planning, partly because they’re more expensive to buy and maintain. However, it is possible to find lower-cost annuities with reduced surrender fees and low commissions.
- Interest rate risk. Anytime you invest in a fixed-rate investment vehicle, your funds are exposed to interest rate risk. Depending on the length of your guarantee, you risk receiving a lower rate or missing out on higher rates in future years.
- Credit risk. Though there is always the risk that an insurer does become insolvent, insurance companies are much better capitalized than banks. Moreover, annuity owners are protected by their state guaranty fund. You can reduce credit risk by selecting the most highly-rated life insurers (A+ from Best, AAA from Moody’s or Standard & Poor’s).
- Inflation risk. Most “safe” investments can expose your funds to inflation risk. That shouldn’t be a concern if a portion of your investment portfolio is invested in equities, which are a proven hedge against inflation.
Are Annuities Right for You?
Annuities are highly customizable. To find the annuity that works for your needs, consider two things:
- What do you want out of your annuity?
- When do you want your annuity benefits to begin?
Generally, annuities are a good option for you if:
- You have a long-term time horizon.
- You can benefit from tax-deferred growth on your funds.
- You are mainly concerned with safety, stability, and future financial security.
- You want to be able to provide for your spouse or heirs.
If you like the idea of trading a liquid lump sum in exchange for a guaranteed cash flow into the future, then annuities are appropriate for you.
We Can Help
As advances in modern medicine continue to increase the American life expectancy, purchasing an annuity can help mitigate your risk of outliving your savings.
In doing so, you’ll have peace of mind knowing your lifetime income is protected.
Overwhelmed by all of the annuity products on the market today? We can help. Please fill out the form below. We look forward to hearing from you.