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.
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.
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- What is an annuity?
- Annuities are one of the most flexible savings vehicles today.
- How do annuities work?
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 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.
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.
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.
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.
5 major types of annuities:
- Fixed Annuities
- Variable Annuities
- Fixed-Indexed Annuities
- Immediate Annuities
- Deferred Annuities
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.
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.
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What are Contract Riders?
Death Benefit 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.
Pros and Cons of Annuities
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.
Get in touch today to start the conversation!
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