Annuities are complex products that come in many shapes and sizes and understanding whether one is right for you can be confusing. Don't worry. We're here to help. Read on to learn what an annuity is, the different types of annuities you can choose from, and pitfalls to avoid when purchasing one.
Annuities may not be as commonly used for retirement income as other well-known products, such as 401(k) plans, but they can provide a valuable stream of income during retirement that supplements Social Security or pensions.
Here's how they work.
An individual contributes money upfront or makes regular payments into the annuity ahead of time, and in exchange the company backing the annuity agrees to pay out a certain amount of income over a pre-specified time period, such as a set number of years or until the death of the annuitant. The amount of income that is paid out can be based on either a fixed or a variable rate of return, and we'll get to the differences between those two in a minute.
First, let's consider a few general benefits that annuities can offer individuals:
- There is no contribution or income limit governing how much money can be stashed away in an annuity;
- Annuities grow tax deferred, which can increase the total value of the annuity significantly over time;
- Annuities can provide a knowable income stream during retirement, providing peace of mind;
- There is no requirement to withdraw money from an annuity at a specific age, nor is there an age limit for establishing one.
Now, let's consider some disadvantages of annuities:
- The fees associated with annuities can be big;
- Growth in an annuity is taxed at ordinary income rates upon withdrawal;
- Withdrawals prior to age 59.5 result in a 10% additional penalty;
- Certain annuities do not provide a benefit for beneficiaries upon death.
Types of annuities
As promised, let's dig a bit deeper into the two types of annuities: fixed rate annuities and variable rate annuities.
Fixed rate annuities pay out a specific amount of income that is based on a fixed rate of return. Because returns don't fluctuate, fixed rate annuities may offer clarity that can provide retirees with a greater sense of peace of mind regarding financial security in retirement.
However, fixed rate annuities, by their nature, do expose annuitants to inflation risk. Over time, the purchasing power associated with income tied to a fixed rate annuity will diminish. Historically, inflation has averaged 3% annually, and if inflation continues at that pace, it could significantly reduce how far you can stretch fixed rate annuity income.
Fixed rate annuities are often less expensive than variable rate annuities because, unlike fixed rate annuities, variable rate annuities allow investors to pick from a menu of investment options, such as stock and bond mutual funds, that charge fees on top of fees typically associated with an annuity.
The ability to pick an underlying investment option may sound enticing to investors given historical market returns, especially since it can reduce risks tied to inflation; however, there's no guarantee that variable rate returns will outperform a fixed rate annuity, so they're far from a risk-free option.
In addition to selecting whether or not to purchase a fixed or variable rate annuity, various pay-out options exist, such as income for a guaranteed period, lifetime payments, income for life with a guaranteed period certain benefit, and joint and survivor payments.
Choosing between those payment options can have a big impact on your family's financial security.
For example, choosing income for a guaranteed period means receiving payments for a specific number of years, after which you won't receive anything. Although payouts for this option may be higher than other options, the fact that you can outlive your annuity income could be a deal-breaker.
Other payout options have similar drawbacks. For instance, lifetime payments eliminate the risk of outliving your annuity income, but insurers don't have to pay anything to your heirs when you pass away.
Because different payout options have big implications on legacy planning, it's important to consider your choices carefully before making a decision.
And another thing
Failing to shop around is one of the biggest mistakes an annuity buyer can make. Annuities are expensive, and it's common to see expenses total 2% to 3% annually. Additionally, surrender charges -- the amount you have to pay if you withdraw from your annuity within a few years of establishing it -- can be onerous, totaling 7%, or more, of the amount withdrawn. Because of their fee structure, annuities are an attractive option for financial planners to sell, and because of that, make sure to do some research independently before buying one that is recommended to you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.