An annuity can be a useful retirement savings tool, but it's important to understand how annuities work before you buy one. Here are six key rules to consider before you invest in an annuity.
1. Your contributions are not tax-free
One major benefit of traditional IRAs and 401(k) plans is that they let you contribute money on a pre-tax basis, which lowers your immediate tax liability. Annuities, however, work differently. When you purchase an annuity, you'll need to fund it with after-tax dollars, which won't save you money on your taxes up front. Now you can hold an annuity within a retirement account like an IRA or 401(k), but it's your initial plan contribution that will save you money on taxes; you won't get an additional tax break for choosing an annuity over a different investment.
2. Your money will grow tax-free
Though you can't open an annuity with pre-tax dollars, once you fund your annuity, your money can grow on a tax-deferred basis. What this means is that you won't pay taxes on the income your annuity generates until the time comes to take withdrawals.
3. Your withdrawals will be taxed
When you withdraw money from a traditional IRA or 401(k), your distributions are taxed as ordinary income. The same holds true for annuities, though the process by which they're taxed is a bit more complicated. Annuities are typically taxed on a last-in, first-out basis, so when you withdraw from an annuity, the money that comes out is initially considered earnings and taxed as ordinary income. But once your annuity value falls below the total amount you paid in premiums, you won't have to pay taxes on withdrawals.
4. Early withdrawals could cost you
Because an annuity is designed to provide income in retirement, if you withdraw from an annuity before reaching age 59 ½, you could face a 10% early withdrawal penalty, which is also what you'd face if you were to take money out of a traditional IRA or 401(k) before 59 1/2. Furthermore, you'll be liable for taxes on whatever earnings your money generated while it sat in your annuity. The amount you contributed initially, however, will not be taxed. Though there are exceptions -- early withdrawals generally aren't penalized if you die or become permanently disabled -- they're not scenarios you want to bank on.
Furthermore, annuities come with a surrender period during which you're not allowed to withdraw funds. If you take money out of an annuity before the surrender period ends, you'll be hit with a surrender charge. Now there are sometimes exceptions. Certain annuity contracts allow you to withdraw up to 10% of your account's value each year without penalty. Similarly, many contracts waive surrender charges if you die, become terminally ill, or are permanently moved to a nursing home. You should fully understand how your annuity works before taking early withdrawals.
5. You can cancel your annuity if you do so right away
If you have second thoughts about purchasing an annuity, you may be in luck provided you act quickly. Annuities typically come with what's referred to as a free look provision, which basically gives you the right to change your mind and get your money back in full if you act within a certain timeframe after signing your contract. Since annuities are regulated at the state level, that free look period can vary depending on where you live. Generally speaking, you can avoid paying a surrender charge if you cancel your contract within 10 to 30 days of signing it.
6. You can contribute as much as you'd like
One major drawback of IRAs and 401(k)s is that they're subject to annual contribution limits. With an annuity, however, you can contribute as much as you'd like within the same year. This is a huge plus if you're looking to save more for retirement than your IRA or 401(k) currently allows for.
Annuities can be a great source of retirement income, but they also come with certain limitations. Before you sign an annuity contract, make sure you understand what you're getting into. More so than that, take some time to think about the pros and cons of annuities so that you wind up making the best decision for your financial future.