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Should You Buy an Annuity?

By Wendy Connick – Jun 20, 2017 at 12:45PM

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An annuity is a somewhat controversial method for producing retirement income.

If the idea of running out of money in retirement really haunts you, then looking for income sources that will keep going as long as you do may be a good idea. The annuity, an insurance product that turns your invested money into a stream of ongoing income, is one such option -- but it comes with some potentially significant drawbacks.

Fixed versus variable

While the basic concept of an annuity is simple, the amazing number of alternatives associated with this product can make it fiendishly complex. For example, annuities can have either fixed or variable payments. A fixed annuity pays a set amount every month based on the amount of your initial investment, while a variable annuity pays out an amount that will change from month to month depending on how your initial investment is performing. Some variable annuities come with certain guarantees, such as a promise that your payment will never drop below a certain amount even if your investments are totally depleted.

A $100 bill with a lock around it.

Image source: Getty images.

Deferred versus immediate

Another important factor to consider is whether you will start receiving payments immediately (an immediate annuity), or whether your investment will sit and hopefully grow until you're ready to start using the money (a deferred annuity). If you decide to take back the money you've invested, you may owe the insurance company a surrender charge with both forms of annuity. Typically, this fee disappears after you've owned the annuity for five to seven years, but check your policy for specifics.

Annuity advantages

Annuities share many of the tax advantages you'd get from a 401(k) or IRA -- you won't owe income taxes on the money you invest in an annuity, nor will you have to pay taxes on the gains (though once you start getting payments, they'll be taxed as ordinary income). And unlike other types of tax-deferred retirement accounts, there's no contribution limit on an annuity.

When you start taking payments from your annuity, you can choose to receive payments either for a set length of time or for the rest of your life. The latter option can give a retiree considerable peace of mind, and if you outlive your projected lifespan, you could end up making a really nice return on your initial investment.

Annuity disadvantages

Annuities are notorious for charging high fees: An annuity sold by an insurance broker or salesperson will likely include a commission to the broker, and this can be as much as 10%. Other charges include the aforementioned surrender charge if you cancel the annuity within the first few years, and for variable annuities, annual fees of up to 2% to 3%. That's a whole lot more than you'd pay on fees if you invested in a typical mutual fund, instead.

If you start taking payments, or withdraw your investment before you reach age 59 1/2, you'll have to fork over a 10% early withdrawal penalty to the IRS. And if the company that sold you the annuity should fail, you could lose not only your monthly checks, but also the money you invested in the first place.

Who should consider annuities?

For most people, it makes more sense to put the money they're saving for retirement into a 401(k) or IRA rather than an annuity. You get the same tax breaks, and the risks (and fees) are typically lower. However, if you've maxed out your contribution limits for the standard tax-deferred accounts and have more money to tuck away, an annuity can be a good place to put that extra money.

Another option is to wait until you retire and then take a chunk of the money you've saved in your 401(k) or IRA and use it to buy an immediate annuity. That will give you a guaranteed source of income and can ensure that you can cover at least your basic expenses for as long as you live, no matter what happens in the stock market. This approach makes the most sense if you're in good health and expect to outlive your predicted lifespan.

Choosing an annuity

First, stay away from insurance brokers. If you buy an annuity straight from an investment company instead of an insurance salesperson -- a product known as a direct-sold annuity -- you'll avoid commissions and probably surrender charges, as well. Given how steep commissions can be on annuity products, this step alone can save you a fortune. Second, don't buy any annuity product unless you are 100% sure that you understand it. Some annuities bury their less-enjoyable rules, fees, and requirements deep in the policy documents where they are almost impossible for non-lawyers to find.

For most people, a simple fixed annuity is the best choice. While you won't get any help with inflation, you also won't be hit with the high annual fees associated with variable annuities. Also, with a fixed annuity, you'll know exactly what amount you'll be getting each month.

Finally, only choose annuities that are sold by extremely stable companies with high credit ratings. You don't want to sink a chunk of your savings into an annuity only to have the company go belly up 20 years later and take all your money with it.

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