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What Is An Annuity, How Does It Work And Is It Worth The Investment?

8-minute read

It’s super easy to get a headache when researching all of the investment tools that exist to help you retire (like mutual funds or an IRA). It can get even more complicated when you throw annuities into the mix.

Understanding what an annuity is and how it works can be simple; the real problem is figuring out how it will work within your current and future lifestyle. 

We’ll cover what an annuity is, if it’s worth the investment, its advantages and disadvantages, and finally, who should or shouldn’t purchase one.

What Is An Annuity?

In plain English, an annuity is an insurance product offered by an insurance company that functions as a retirement tool.  

The goal of an annuity is to make sure you don’t outlive your retirement savings.

How Does An Annuity Work?

Basically, you pay the insurance company either a lump-sum payment or multiple payments. In return, they promise to pay you a regular income either immediately or in the future. 

This makes an annuity a pretty neat benefit if you’re looking to retire, because you get to put a single payment into a product that pays you back when you need it. 

While these products may be simple to explain, they are very involved in nature and can be very confusing when trying to learn how they work. 

How To Buy An Annuity

The best way to buy an annuity is to get quotes like you would with any insurance product, because the payout amounts and options will vary. 

You also might want to buy annuities from more than one company based on your state’s guaranty association limits. 

Of course, you also want to make sure you check that the annuities are financially secure by making sure they have an “A” rating or better from Moody’s, A.M. Best, Fitch, or Standard & Poor’s. 

Once you decide to purchase an annuity, you will be able to make a lump-sum payment or monthly installment payments. 

The payment option you choose can also affect how your annuity is paid out.

Phases Of An Annuity

There are two phases of an annuity: accumulation and annuitization. 

Accumulation Phase – The phase of an annuity during which you’re making payments and building up cash value. Usually, this is in the early stages. Once this is over, you flow into the annuitization phase. 

Annuitization Phase – The phase of the annuity when all the money you invested turns into periodic income payments. You can choose to have the payments annuitized for a set period or for as long as you live. 

Payments from an annuity can only be made to either the annuitant or to the annuitant’s beneficiary after their passing.  

Payout Plans 

One major factor that determines how your annuity will work is your payout schedule. You have two options: an immediate annuity or a deferred annuity. 

Immediate Annuities – An immediate annuity will start paying out 30 days to 1 year after you have purchased it. These will be best to buy when you are close to retirement or during your retirement.  

Deferred Annuities – This type of annuity will pay out at a later time specified by your contract. Mostly it consists of you paying into the policy for several years. At a specific point, it will start to give payouts.

Keep in mind that even though both methods are considered tax-deferred, the actual savings will come from a deferred annuity.  

Because you get to grow your money without any taxes being placed on it until you start receiving payouts, deferred annuities allow more savings.

How Annuities Are Taxed

While understanding how you will be taxed for anything is critical, it’s even more critical when it comes to your annuity.

Remember, as long as you aren’t receiving payouts, your balance will continue to grow tax-free.

However, once you start getting disbursements, you’ll be taxed on that income.

There’s also an option to do a lump sum cash-out on your deferred annuity. Still, if you choose this option, any gains you made outside of your initial investment will be taxed. 

For instance, if you invest $40,000 into a deferred annuity, and after 20 years the account is worth $100,000, you would have to pay taxes on the $60,000 growth before you can take out the $40,000 tax-free. 

What Are The Advantages Of An Annuity?

You’re probably wondering why someone would want to buy an annuity. Here are a few strong reasons why an annuity can be a fantastic purchase:  

Benefitting A Beneficiary – If you pass away and there is still money associated with the annuity, the remaining payouts can start going to your beneficiary. 

Principal Guarantee Options – One of the best choices you can make is an annuity that offers a guarantee on the principal you invest. This is just another fail-safe to make sure that when it’s time to take payouts, there is at least your initial investment left.

Unlimited Contributions – A fantastic benefit of annuities is that they don’t have yearly contribution limits. This gives you the ability to put away a ton of money and defer paying taxes on it.  

You Won’t Outlive Your Savings – Believe it or not, the average life expectancy in the U.S. is going to keep getting longer, especially with all of our technology and medical breakthroughs. The longer we live, the longer our money needs to be available to us as well. An annuity gives you the ability to have a guaranteed stream of income, no matter how long you live.

Tax Deferrals – As we discussed briefly, earnings on annuities are tax-deferred. This means as long as you don’t take withdrawals on your money, you don’t pay taxes on the gains. If you expect to be in a lower tax bracket when you get older, this is an amazing feature.

What Are The Disadvantages Of An Annuity?

While there are some solid reasons to obtain an annuity, you will find that there are also several things that can make an annuity a lousy idea: 

Money Can Be Hard To Access – Once your terms have been set, it might be too expensive to take out any funds, or, depending on your contract, you might not be able to access the funds. You’ll find it especially hard to get them once your distribution is set or starts paying out. 

Surrender Charges – It’s critical to understand when you’ll have to face a surrender charge. These will vary based on the insurance company you have your policy through. If you don’t pay attention, you could end up paying a fee or (surrender charge) based on how much money you take out. You’ll also be taxed 10% if you take your money out before age 59½.

Management Fees – Managing the money inside of your annuity does cost money, and that’s where your management fee comes into play. This fee will be different depending on the insurance company you choose.

Additional Riders – Like most insurance policies, an annuity comes with additional riders that you can purchase for other features on your policies. It could range from adding a long-term care benefit to even better income guarantees.

Mortality & Expense Risk Fee (M&E Fee) – This is a fee insurance companies attach to your policy that allows them to assume the risk that you’re going to live longer than expected. This fee can range anywhere from .5% – 1.5% of the policy’s value per year.

Taxes – The most significant downside to an annuity is the fact that you are going to be taxed when you start receiving payouts. The amount of tax is going to depend on your current income tax rate, which can range from 10% – 37%.

What Types Of Annuities Are There?

The type of annuity you want is another huge factor you need to pay attention to as well. There are a few different options for an annuity, and they all come with their own pros and cons. 

Fixed Annuities: 

A fixed annuity is going to pay out a guaranteed amount; however, it’s going to have a meager annual return/rate, usually only a bit higher than a CD. Think of this as a savings account with an insurance company.

Variable Annuities:

Variable annuities give you the ability to have a higher return on your money. Still, they also come with a higher risk. You’ll pick from a list of mutual funds that will go into your “sub-account.” Your retirement payouts will be based on the performance of the investment in your sub-account. 

Indexed Annuities: 

Think of an indexed annuity as the middle ground in regard to risk and reward possibility. You get a guaranteed minimum payout, and a portion of your return will be tied to the performance of a market index, like the S&P 500.

The type of annuity you choose will ultimately determine the kind of payouts you receive when you start to take disbursements. 

Who Should Invest In An Annuity?

Just like a whole life insurance policy, annuities aren’t going to be the right choice for most people. Along with being a complex product, an annuity offers some high fees. Below is a breakdown of who should and shouldn’t consider an annuity. 

Who Should Consider An Annuity?

Figuring out if an annuity is right for you will come down to your specific financial situation and your age. If you can relate to the situations below, an annuity might be a good choice for you: 

You’re part of a high tax bracket: Being in a higher tax bracket now means that a much more substantial amount of your money will be going to Uncle Sam. However, if you put the money into an annuity, it will be tax-deferred until you start drawing on the cash. At a later date, you could be at a much lower tax bracket and only pay taxes based on that lower rate. To figure this out, it’s best to determine if it costs more to pay taxes or more to pay the fees of an annuity.

If you’re worried about outliving your retirement savings: A huge concern for people as they get closer to their retirement age is that they will end up outliving their actual retirement savings. 

This is easily understandable with how the economy can fluctuate very quickly from stable to hectic. 

An annuity is a sure bet to having a set rate that will pay out for the rest of your life. 

Someone expecting to live longer than average: An annuity is a fantastic asset if you plan to live longer than average. Right now, the average life expectancy in America is 78 years old. If you expect to live well past that age, then you probably need to think about how an annuity could work for you. 

Who Should Not Purchase An Annuity?

Annuities won’t work for every situation. It probably will make more sense for you to save or invest your money rather than buy an annuity if: 

  • your Social Security benefits cover all your expenses
  • you have pension benefits that will cover all regular expenses
  • there are high-risk health problems you’re dealing with
  • you’re someone with a higher tolerance for risk

Of course, there are more reasons why someone shouldn’t purchase an annuity, but remember that each annuity will function differently based on your needs, current income level, tax bracket, and your specific age.

In Conclusion

Overall, the average person won’t find an annuity investmentto be a suitable retirement tool because of the amount you need to put into an annuity up-front, as well as the fees. 

And before deciding on an annuity, you should absolutely read our article about additional ways to save for retirement because it could save you time and money.  

You don’t have to put all of your eggs in one basket when it comes to retirement. There are several options, and an annuity is just one of them. 

Your main goal should be figuring out what tools will allow you to retire and not outlive your money.

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