You might already have an opinion about annuities. Maybe you're strongly for them, or strongly against them. There's also a good chance that you don't know much about them and you'd like to learn more.
Annuities have a purpose in an investment account but they're not a good fit for everyone. Here are four upsides and downsides about annuities that will help you decide if you could benefit from buying one.
An annuity is a contract between you and an insurance company. You fund your annuity with either a lump sum of money or in increments over time. In exchange for your payment, the insurance company will provide you with either your lump-sum payment back in the future (with interest) or a guaranteed income stream that you can start collecting either immediately or at a later date .
1. Fixed annuities offer high rates but come with some catches
A fixed annuity is simple. The amount of income you receive is based on a predetermined rate which usually corresponds with a term. It can provide you with diversification outside of your bond portfolio or if you're frustrated with the low rates that CDs offer, it will usually pay you a higher rate. If you purchase a 5 year CD, you can expect to earn 1% on average but if you use that same money to buy a fixed annuity, you can earn as much as 3%..
In general, fixed investments don't keep pace with inflation well. You get comfort in knowing exactly what you can expect but each year but might find yourself struggling with maintaining your cost of living. With fixed products, you're also locked into your rates and if they rise, you can't always take advantage of them. Annuities have very little flexibility and if you sell your annuity before your holding period is over, you are assessed with a fee called a surrender charge, which, depending on how much time is left in your term, can be quite large.
If you value predictability over flexibility, a fixed annuity could add value to your portfolio. If, however, you have liquidity needs in the near term, limits on accessing your money would make this type of investment less suitable.
2. Variable annuities offer market exposure but often have high costs
Variable annuities help your income keep pace with inflation better than fixed annuities. They are a little more complicated though and your income is usually tied to the value of the funds it is invested in. If they perform well, your annuity will grow.
For example, if you buy a variable annuity for $50,000, and in the year that you retire it has doubled to $100,000, your withdrawal rate is now based on your higher account value. The insurance company you buy your annuity from might also provide some type of minimum income guarantee in the event the markets don't do well and your account doesn't grow. If instead, your annuity shrunk to $25,000 by the time you retire, the insurance company will usually offer some type of minimum rate that you can depend on..
This type of benefit makes a variable annuity more costly than a regular investment account and the extra fees can eat away at your investment return. Your account value is also reduced by any withdrawals you make and if the percentage of withdrawal you're taking exceeds the growth rate of your account, your account will get depleted. You can still depend on income, but say goodbye to your principal.
A variable annuity will give you income, but if preserving your principal is just as important to you, you might get frustrated with this type of investment. Additionally, if you are very conscious of fees, this type of investment is not for you.
3. Annuities offer tax deferral but without upfront deductions or tax-free growth
If you are someone who pays a lot of taxes, you can use an annuity to create a tax-deferred investment and reduce your liability. If you add non-retirement money to an annuity, any contributions you make as well as interest or dividends that pay into your account grow tax-deferred.
While your investment grows tax-deferred, you do pay taxes when you start taking withdrawals. The rate that you pay taxes at if you funded your annuity with after-tax dollars will take into account how much of your withdrawal is from your principal (which you've already paid taxes on) and how much of it is attributed to growth (which you haven't paid taxes on).
The benefit of tax deferral comes at a cost and when you start an annuity you are subject to the same tax penalties that other retirement money is subject to. If you take money from your annuity before reaching the age of 59 1/2, you'll owe a 10% penalty on any portion of your withdrawals that you owe taxes on plus the taxes. This puts limits on your taxable money that you wouldn't have in a regular brokerage account and if you're considering an annuity for this purpose, you should remember this limitation and weigh the benefits carefully.
You can also fund your annuity with retirement money. But if you're doing so, tax advantages shouldn't be your main objective since these accounts already have the benefit of tax deferral. A good reason for buying an annuity with your 401(k) or IRA is for the income stream. Since most employers don't offer pensions anymore, you can create your own pension-like investment with an annuity
Annuities have good and bad qualities and they're not for everyone. Deciding if an annuity is right for you requires that you educate yourself about them and examine your needs. If the pros they provide match your need and outweigh the cons, annuities could make up a very important part of your investment plan.