Annuities
ANNUITIES & RETIREMENT INCOME
Understanding Annuities Before You Buy One
Annuities can play an important role in retirement planning—but they are not appropriate for everyone.
The key is understanding what an annuity is designed to do, what guarantees it provides, what it costs, how your money may be accessed, how it is taxed, and what happens to the contract when you die.
There is no single “best annuity.”
Different annuities are designed to accomplish different objectives.
The goal should not be to buy an annuity. The goal should be to determine whether an annuity appropriately supports your retirement strategy.
WHAT IS AN ANNUITY?
An annuity is a contract issued by an insurance company that can be used for objectives such as accumulating money on a tax-deferred basis or creating an income stream.
Depending on the contract, an annuity may offer features related to:
- Guaranteed income
- Principal protection
- Tax-deferred accumulation
- Market-linked growth potential
- Lifetime income
- Spousal income
- Death benefits
- Long-term-care or chronic-illness features
Features, guarantees, costs, restrictions, and risks vary significantly by contract.
THE MAJOR TYPES OF ANNUITIES
Fixed Annuities
A fixed annuity generally credits a stated or declared interest rate according to the terms of the contract.
It may appeal to someone seeking predictability and protection from direct stock-market losses.
Learn More: What Is a Fixed Annuity?
Fixed Indexed Annuities
A fixed indexed annuity credits interest based in part on the performance of an external market index, subject to the contract's crediting method, caps, participation rates, spreads, or other limitations.
You generally do not own or directly participate in the index.
Learn More: How Does a Fixed Indexed Annuity Work?
Variable Annuities
Variable annuities allow money to be allocated among investment options, often called subaccounts.
Account values can rise or fall based on investment performance, meaning the owner assumes investment risk.
Learn More: Variable Annuity Pros and Cons
Immediate Annuities
With an immediate annuity, a lump sum is generally exchanged for payments that begin relatively soon.
They are primarily designed to convert assets into an income stream.
Learn More: How Does an Immediate Annuity Work?
Deferred Income Annuities
A deferred income annuity is designed to begin income payments at a future date.
This can potentially help address longevity risk—the possibility of living longer than anticipated and exhausting other resources.
Depending on the contract and your circumstances, an annuity may help address several retirement concerns.
1. Create Predictable Retirement Income
One of the primary reasons people consider annuities is the ability to create an income stream.
Certain guarantees may continue for a specified period or potentially for life, depending upon the contract and elections made.
One of retirement's biggest uncertainties is:
How long will I live?
Lifetime-income features can potentially transfer some longevity risk to an insurance company.
3. Provide Tax-Deferred Growth
Earnings inside a nonqualified annuity generally grow tax-deferred until withdrawn.
Tax-deferred, however, does not mean tax-free.
4. Reduce Direct Exposure to Market Losses
Certain fixed and fixed indexed annuities may protect principal from direct stock-market losses, subject to contract terms and the insurer's claims-paying ability.
That protection normally comes with trade-offs.
5. Provide Beneficiary Options
Some annuities include death-benefit provisions or beneficiary features.
The treatment depends upon the specific contract.
WHAT ARE THE DISADVANTAGES OF ANNUITIES?
Potential disadvantages can include:
- Surrender charges
- Limited liquidity
- Early-withdrawal considerations
- Fees and expenses
- Complexity
- Caps or participation limitations
- Inflation risk
- Opportunity costs
- Tax consequences
- Insurer credit risk
- Contract-specific restrictions
Guarantees are only as strong as the claims-paying ability of the issuing insurance company.
Taxation depends on the type of annuity and how it was funded.
For a nonqualified annuity, contributions generally come from after-tax money. Earnings are tax-deferred, and taxable amounts distributed are generally subject to ordinary-income tax rules rather than capital-gains rates.
An annuity held inside a traditional IRA or other tax-deferred retirement account generally does not create an additional layer of tax deferral merely because the investment is an annuity.
This is a frequent source of confusion.
An IRA is an account with particular tax treatment.
An annuity is an insurance contract.
An annuity can sometimes be held within an IRA, but the two terms are not interchangeable.
Similarly, a 401(k) is an employer-sponsored retirement plan.
An annuity is an insurance contract.
The decision does not necessarily have to be:
401(k) OR annuity.
The appropriate question may be how various retirement resources work together to achieve the retiree's objectives.
WHO MIGHT CONSIDER AN ANNUITY?
Depending on circumstances, someone may consider exploring an annuity when concerned about:
Outliving retirement savings
Creating predictable income
Reducing direct exposure to market volatility
Creating income for a surviving spouse
Tax-deferred accumulation
Adding another source of retirement income
But an annuity should be evaluated alongside the person's other assets, liquidity needs, expenses, income sources, time horizon, risk tolerance, tax circumstances, estate objectives, and overall retirement strategy.
Learn More
Annuities are financial products offered by insurance companies that provide a steady stream of income, typically used as a retirement planning tool. Individuals pay into an annuity—either as a lump sum or through periodic payments—and, in return, receive regular payments over a specified period, which could last for a certain number of years or for the rest of their life. Annuities are designed to help retirees manage income and reduce the risk of outliving their savings.