An annuity is a financial contract between you and an insurance company. In exchange for a lump sum payment or a series of payments, the insurer agrees to provide you with regular income payouts, either immediately or at a later date.
Annuities have long been touted as a way to generate guaranteed income in retirement. But people buy annuities for other reasons too, such as the ability to defer taxes and funnel money into an account with no contribution limits.
These are the top reasons why people buy annuities and the factors you should consider before making a decision.
1. Guaranteed income
The main benefit of an annuity is the ability to generate a guaranteed income stream. This means that you can receive regular payments for the rest of your life, regardless of how long you live. This can be especially beneficial if you’re worried about outliving your savings.
“For people that value safety and consistency above opportunity cost, annuities can be a great fit,” says Sean Williams, a certified financial planner and principal at Cadence Wealth Partners. “Annuities provide that steady, predictable paycheck they need to complement their Social Security checks.”
In fact, the opportunity to generate guaranteed income was the top reason people gave for buying an annuity, according to a 2022 survey by LIMRA, the largest insurance trade association in the U.S. Most buyers said they planned to use the annuity to either supplement a Social Security or pension check or to generate lifetime income.
People often worry about running out of money in retirement because no one knows exactly how long they’ll live. Annuities can provide a sense of security by guaranteeing a kind of paycheck replacement, even if you live to be 110.
For example, if you have $1 million in savings and you retire at 65, you may be able to withdraw $50,000 a year. However, if you live to be 95, your savings may run out. With an annuity, you can receive regular payouts year after year, regardless of how long you live. You might even receive years of annuity payments that the insurer didn’t anticipate you collecting.
Unlike other investments, most annuities come with a guarantee, in part because they’re technically financial contracts issued by an insurance company, not traditional securities. Other investments will likely earn you a higher return, but you have to be willing to stomach the risk.
Just keep in mind that the guarantee behind an annuity is only as strong as the insurance company selling it. So do your homework and find a provider that’s financially rock solid. Look for annuity companies with a good track record and positive customer reviews.
2. No contribution limits
Like traditional retirement plans such as a 401(k), qualified annuities have limits on how much you can contribute each year. But nonqualified annuities, which are much more common and funded with after-tax dollars, have no contribution limits.
Individual life insurance companies set maximums on how much money you can use to fund an annuity, but nonqualified annuities (that is, annuities purchased outside a retirement account) don’t have contribution limits imposed by the IRS. This means you can contribute as much money as you want to an annuity, up to the maximum allowed by your life insurance company.
This can be a big perk for wealthy individuals who want to contribute more to their retirement savings but have maxed out other accounts, such as a 401(k) and Roth IRA.
It also makes annuities an attractive option for people who recently received a large inheritance or financial windfall, such as winning the lottery.
3. Tax deferral
Annuities can provide tax-deferred growth until you withdraw the money or begin receiving payments. If you fund a nonqualified annuity with after-tax money, you only pay income tax on the profits, not the principal, when you withdraw money.
However, many other investment accounts — including 401(k)s, IRAs, 529 plans and even HSAs — also defer taxes on your investments, so annuities aren’t unique in that respect. And annuities pale in comparison to the tax benefits of a Roth IRA, which allows you to avoid paying taxes entirely on withdrawals in retirement.
You can also buy an annuity inside a Roth IRA or Roth 401(k), which means your payouts will be completely tax-free. But many experts think it’s a bad idea to stack tax-advantaged accounts like these. It’s like putting a fancy lock on a lockbox — it doesn’t make a lot of sense and it can be a pain to deal with.
4. Set it and forget it
Once you purchase an annuity, you don’t have to worry about managing your investments or withdrawal strategies. The annuity company will take care of all of that for you. This can be a huge relief if you’re not comfortable managing your own portfolio or you want to simplify your retirement plan.
“We often discount the emotional aspect of financial planning,” says Williams. “But creating an environment of security and safety with an annuity can allow certain people more freedom and fulfillment in their retirement years.”
When you purchase an annuity, you don’t have to worry about researching stocks, rebalancing your portfolio or making decisions about when to buy or sell.
Similarly, you can receive regular payments regardless of what’s going on in the markets, giving you peace of mind. By entrusting the management of your investments and withdrawals to an insurance company, you can save yourself time and potentially reduce stress in the process.
“At the end of the day, the decision around annuities isn’t a matter of math, because that will often favor other options,” says Williams. “It’s a decision around investor mindset.”
5. Customized to fit your needs
Annuities can be customized in many different ways depending on your specific needs. Many annuities include a death benefit, similar to life insurance, that provides a payout to beneficiaries upon your passing.
While annuities are often associated with lifetime income, you can structure contracts for shorter periods too, such as five or 10 years. Additionally, different annuity types are available, including fixed annuities (linked to prevailing interest rates) and variable annuities (tied to the performance of underlying investments).
Some annuities offer survivor benefits, which continue payments to a surviving spouse for a specified period after your death. Many annuities can also be customized with additional riders that provide insurance-like benefits. However, these extra features typically come at a higher cost.
Ultimately, the flexibility of annuities allows you to tailor the contract to your preferences, but keep in mind that you’ll pay more for all those extra bells and whistles.
Downsides of annuities
While annuities can offer a guaranteed income stream in retirement, they come with significant drawbacks. Before purchasing an annuity, consider these factors first.
Complexity and fine print
Annuities are notorious for their complex contracts, which can span dozens of pages. These documents outline details about payment schedules, withdrawal fees, payment amounts, interest rates and other essential information.
Understanding your rights and responsibilities as an annuity owner requires careful scrutiny of the contract, which can be time-consuming and challenging. Seeking guidance from a fee-only financial advisor can be a smart move when combing through the contract.
Commissions and fees
Another drawback of most annuities is the substantial sales commission embedded within the product. While you may not pay the commission upfront, it reduces your overall returns. These commissions can run from about 5 percent to as much as 10 percent of the invested amount.
The potential for big commission checks can incentivize insurance agents to aggressively promote annuities, even if they’re not the right product for your specific financial situation.
Illiquid
Annuities generally tie up your funds for a long time. While you can receive income payments and might be able to withdraw some of the principal, accessing your funds is often restrictive and expensive. This can pose a problem if you need money for an emergency and don’t have sufficient income or savings to draw from somewhere else.
Bottom line
Annuities can be a viable option for people seeking a guaranteed income stream in retirement. However, it’s important to weigh the pros and cons carefully before making a decision. If you’re considering buying an annuity, be sure to talk to a financial advisor first to learn more about your options.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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