We all need income in retirement, but most of us would rather put our money in something we actually understand. There's a lot of confusion around annuities, so here are some of the most commonly asked questions about how they work.
1. How does an annuity differ from a traditional savings or brokerage account?
When you put money into a savings or brokerage account, you're free to withdraw that money as you see fit. However, the income you earn from that money, whether it's interest from your bank, or gains from your investments, is subject to taxes immediately.
An annuity, on the other hand, is a contract between you and an insurance company that requires it to make payments to you, either right away or in the future. Once you fund your annuity, you can't just withdraw your money at any time without consequences. However, that money gets to grow on a tax-deferred basis.
2. What benefits do annuities offer?
Annuities offer tax-deferred growth, so even if the value of your annuity increases year after year, you won't pay taxes on that growth until you actually start taking withdrawals. Furthermore, annuities can help protect you from the one thing most retirees fear: outliving their money. Because you can structure an annuity to make payments for the rest of your life, you can rest assured that you'll keep getting distributions no matter how long that happens to be.
3. What are some of the drawbacks of annuities?
Aside from their complicated nature, the greatest drawback associated with annuities is the fees that come with them. Annuities are often sold by brokers, and therefore often come with commission fees that can be as high as 10%. Some annuities also come with hefty annual fees.
Furthermore, if you attempt to take money out of your annuity too soon, you could be hit with a surrender charge. Surrender charges often hover around the 7% mark if you withdraw your money after the first year, and then generally go down by 1 percentage point a year until they reach zero. But some annuities have longer surrender periods and higher surrender charges, so you need to be really careful about when you withdraw your money.
4. What types of annuities are there?
There are two basic types of annuities: deferred and immediate. With a deferred annuity, you don't get payouts right away. Rather, your annuity has an accumulation period during which premiums are paid into the contract before payouts are disbursed. With an immediate annuity, you can begin receiving payments shortly after your pay into the contract.
Within these two categories, annuities can also be variable or fixed. With a fixed annuity, you're guaranteed a fixed, predetermined rate of income. With a variable annuity, your principal is invested, and your payouts are based on how well your account performs. If you opt for a fixed annuity, you won't have to worry about choosing your own investments. With a variable annuity, you get to decide how that money is invested, which could be a good thing or a bad thing.
5. How much can I contribute to an annuity each year?
Unlike traditional retirement accounts like 401(k)s and IRAs that offer tax-deferred growth, annuities don't come with an annual contribution limit. If you want to exceed the current IRS contribution limits for 401(k)s and IRAs, you might consider an annuity.
6. Can I withdraw money from an annuity at any time?
Withdrawing your money too soon could come with serious repercussions. As is the case with a 401(k) or IRA, if you withdraw money from an annuity before you reach age 59-1/2, you could be hit with a 10% early-withdrawal penalty. And if you take out your money too soon, you could be subject to surrender charges, as well.
7. Will I pay taxes on annuity withdrawals?
Just as you'd pay taxes on distributions from a traditional IRA or 401(k), you'd pay taxes on annuity withdrawals as ordinary income. The process by which annuities are taxed, however, can be somewhat complex. Generally speaking, annuities are taxed on a last-in, first-out basis. When you take annuity withdrawals, the money that comes out initially is attributed to the earnings portion of your account, and so that money is taxed as ordinary income. However, once the value of your annuity falls below the total premium amount you put in, your withdrawals won't be subject to taxes because the money you used to pay those premiums was already taxed up front.
An annuity can be a useful, albeit complicated, retirement planning tool. Just know that the terms of an annuity contract can vary from one to the next. If you're going to purchase one, be sure to understand exactly what you're signing up for.