Are annuities the best way to invest? Image source: Getty Images.

Annuities are one of the most misunderstood financial products available to ordinary consumers. Insurance agents often sell these tax-advantaged insurance products as a way to enhance income, grow your net worth, and get guarantees that can protect you from adverse market movements. Yet before buying an annuity, there are many things you should think about, and it's important to go to the effort to get as much information as you can about the annuity that you're considering before you put down your hard-earned money. Below, you'll find a short guide on annuities that can help you make a smarter decision.

The many aspects of annuities

One problem investors immediately face is that there many different kinds of annuities from which to choose. Fixed annuities involve paying an up-front premium and accepting an insurer's promise to pay you a certain interest rate over a specified period of time, while variable annuities have their value tied to a portfolio of stocks, bonds, or other investments that can move dramatically in price over time. Equity-indexed annuities have their value track a particular benchmark, such as the S&P 500 index, but can also have provisions that limit the maximum loss but put a ceiling on potential gains.

In addition, annuities have add-on features that can offer attractive characteristics but come with a price. Guarantees of minimum income, minimum death benefits for heirs, and total withdrawals from the annuity over your lifetime can protect you from adverse market movements. But you'll also pay higher annual costs for those annuities, and those costs will eat into the value of your annuity over time in ways that can add up to a surprisingly large amount of money.

When annuities can be most helpful

The best aspects of annuities are that they offer tax-deferred growth and that they give you the opportunity to start taking a stream of income that is guaranteed to last the rest of your life. Many buyers therefore focus on immediate annuities, in which you simply exchange an up-front payment for a certain monthly payment for the rest of your life. If you live longer than your life expectancy, then you'll end up the winner on an immediate annuity. If you die sooner, then the insurance company profits.

A variant on immediate annuities is the deferred income annuity. With this contract, you pay your money up front, but you don't start getting payments until a set time in the future. For example, a new retiree at age 65 who wants to ensure a stream of income beyond age 85 might by a deferred income annuity that starts making payments 20 years from now. The longer the delay, the larger the monthly payment will be when the annuity kicks in -- but the greater the chance that the person will die before collecting any payments at all.

Taking advantage of other opportunities

Perhaps the most overrated aspect of annuities is their tax-deferred status. Tax deferral is valuable, but most people fail to take full advantage of more flexible tax-favored options available to them. For instance, an IRA allows you to invest in lower-cost investment vehicles, with contributions of up to $5,500 annually for those younger than 50 or $6,500 for those 50 and older. Limits on 401(k) employer retirement plans are even higher, at $18,000 and $24,000 respectively depending on your age.

Typically, it makes more sense to take full advantage of IRAs and 401(k)s before turning to annuities as a tax-advantaged investment. That way, you can minimize costs and retain maximum control over your money.

Annuities do serve a purpose, and there are definitely situations in which buying an annuity is the best way to handle the risk of outliving your money. As a simple investment, however, annuities can be expensive both in terms of ongoing expenses and because of the fees you can incur by trying to take your money back out too soon. Once you're comfortable that you've saved enough to make ends meet for the remainder of your lifetime, annuities usually won't be the optimal solution to meet your financial needs.