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An annuity is an investment that's typically used to generate income in retirement. It's a contract you make with an insurer that can provide guaranteed cash disbursements in the future. They come in several shapes and sizes, but annuities are designed to prevent people from outliving their money.
An annuity can be one part of an overarching retirement planning strategy, but they aren't for everyone. Here's an explainer of how they work and who should consider investing in one.
How Annuities Work
Annuities are available through insurance companies, though some banks, brokerage firms and mutual fund companies also sell them. One benefit is that they provide tax-deferred growth. That means you won't pay taxes on investment gains until you withdraw the money, but you can expect to pay fees along the way. Costs vary depending on the type of annuity you purchase. (We'll break this down below.)
Annuities are commonly structured in one of two ways:
- Accumulation annuities: These allow you to save for retirement. Some work sort of like a certificate of deposit (CD) or mutual fund. The goal is to put money in and net a return down the road. With an accumulation annuity, your premiums are invested and grow tax-deferred for a set period of time.
- Income annuities: You can purchase this type of annuity with a single lump-sum payment or through a series of payments. After that, you'll receive periodic income payments for a predetermined amount of time. Some annuities provide guaranteed payments for the rest of your life.
When Do You Start Getting Payments From Annuities?
When your annuity payments begin depends on the type of annuity. With an immediate income annuity, you pay your premium upfront and begin receiving payments usually within one to 13 months. Deferred income annuities don't distribute payments until a predetermined point in the future. These future income payments are usually more than what you'd get with an immediate annuity.
What Happens to an Annuity When You Die?
If you have an annuity with a death benefit provision, your beneficiary can receive some portion of your benefit for a certain number of years. These details should be spelled out in your contract. Couples, for example, may opt for a joint-life death benefit. With this option, payments are generally higher when both people are alive. If the first person dies, the second person will receive a decreased amount.
How Do Taxes Work With an Annuity?
Your tax liability depends on whether your annuity is qualified or non-qualified.
- Qualified annuities are purchased with pretax funds. You'll be taxed when you receive funds, and you must begin taking required minimum distributions at age 72.
- Non-qualified annuities are funded with after-tax dollars. Only investment gains are taxable.
Do Annuities Have Fees?
Fees vary depending on the annuity type and insurer. Here's a typical breakdown, according to annuity provider Canvas.
| Annuity Fees | |
|---|---|
| Type of Annuity | Typical Fees |
| Fixed annuity | 1% to 3% |
| Variable annuity | 4% to 7% or more |
| Indexed annuity | 6% to 8% or more |
Source: Canvas
According to the U.S. Securities and Exchange Commission, other charges might include:
- Mortality and expense risk fee: This compensates the issuer for taking on risk. It's typically around 1.25% per year.
- Administrative fees: This might be charged as a percentage of your account value or as a flat annual fee.
- Withdrawal penalties: You'll likely be hit with a 10% IRS penalty if you withdraw money before age 59½.
- Surrender penalties: Variable annuities have a surrender period, which is usually the first six to eight years. You'll likely be penalized if you sell or withdraw money during this time.
- Underlying fund expenses: If your annuity includes underlying mutual fund investments, there may be additional fees.
You can also expect to pay more if you add special features to your annuity, like tacking on long-term care insurance or requiring a minimum income benefit.
Do Income Annuities Provide Cost-of-Living Adjustments?
Some annuities allow contract holders to add a cost-of-living rider. This will boost their annual payments to help them keep up with inflation. If you go this route, keep in mind that your insurer may reduce your monthly benefit before calculating your annual adjustment. Always read the fine print to be sure the numbers are compatible with your retirement income plan.
Types of Annuities
Fixed Annuity
With a fixed annuity, you can choose lifetime payouts or receive payments for a shorter time. This can be appealing to retirees who want a reliable return that isn't affected by the stock market. Its fees are also on the lower side when compared to other annuities.
Fixed annuities offer a guaranteed interest rate for a certain period of time, though the name can be misleading. According to the Financial Industry Regulatory Authority (FINRA), a fixed annuity contract could periodically change the interest rate based on current rates. (Again, be sure to read your contract carefully.)
Variable Annuity
The rate of return for a variable annuity fluctuates. If you invest in stocks, bonds or money market accounts through your annuity, you can expect your rate to go up and down alongside those markets. Variable annuities are similar to mutual funds when it comes to investment choices and features, but their tax-deferred growth and higher fees set them apart.
You'll pay premiums that are invested in subaccounts. The insurer then makes minimum payments back to you that are determined by your initial investment—plus any gains or losses. Returns are not guaranteed.
Indexed Annuity
Indexed annuities blend features of fixed and variable annuities. In terms of investment risk, they're right in the middle. They mix a minimum guaranteed interest rate with a second rate that's tied to a market index like the S&P 500.
Indexed annuities can be complicated for the average investor to understand. For example, the indexing methods used to calculate gains are often confusing and unclear. It's important to understand all the features of a particular indexed annuity before investing.
Pros and Cons of Annuities
Pros
- Helps you build your nest egg ahead of retirement
- Can provide guaranteed income when you retire, regardless of market volatility
- Diversifies your investment portfolio
- May provide a death benefit for beneficiaries
Cons
- Fees and penalties may apply, which can eat into your investment returns
- Not all annuities offer guaranteed returns
- Annuities are not insured by the FDIC or SIPC
Should You Invest in Annuities?
Investing in an annuity might make sense for someone looking for a steady stream of income in retirement. It can also be part of your estate plan and left to a beneficiary after you're gone.
Annuities often come with fees, so you'll want to make sure it gels with your greater retirement income plan. They also don't provide much in the way of flexibility. If you want to tap your funds early, you'll be penalized.
The Bottom Line
For some, an annuity is a worthwhile investment in retirement. After paying your premiums, you could have a guaranteed return waiting for you on the other side. Like anything else, annuities have their drawbacks and won't make financial sense for everyone.
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