Many savers shy away from annuities because they don't really understand how they work. While annuities can be somewhat complex, they can also be a valuable retirement savings tool. If you're getting close to retirement, here are a few things you ought to know about annuities.
1. You can contribute as much as you'd like
IRAs and 401(k)s are popular retirement savings tools below they allow for tax-free contributions. Annuities offer no such benefit; the money you put into an annuity is money you've already been taxed on. But one thing IRAs, 401(k)s, and annuities do have in common is the ability to benefit from tax-deferred growth on your investments.
IRAs and 401(k)s, however, come with one major drawback -- you can only contribute so much in a given year. Currently, the annual limit for an IRA is $5,500 if you're under 50, or $6,500 if you're 50 or older. Meanwhile, the 401(k) limit is $18,000 if you're under 50, or $24,000 if you're 50 or older. Now for many savers, these limits are more than generous. But if you're looking to sock away additional cash for retirement and feel constrained by these limits, you can opt for an annuity and fund it with as much money as you'd like. That said, you're usually better off maxing out your IRA or 401(k) first, and then putting whatever excess cash you have into an annuity.
2. Withdrawals are restricted
The purpose of an annuity is to provide income in retirement. Just as IRAs and 401(k)s impose early withdrawal penalties for removing money before age 59-1/2, so too will you face a 10% penalty if you take an annuity distribution prior to that same age. Though there are rare exceptions to the penalty, such as if you become permanently disabled or, worse yet, pass away, if you're going to fund an annuity, you should go in expecting to leave that money in place until you're older.
Additionally, annuities come with what's known as a surrender period, and during this timeframe, any funds you withdraw will be subject to a surrender charge. Surrender charges frequently start at 7%, though they do decline year over year as the surrender period winds down. While some annuities will allow you to withdraw up to 10% of your account value per year penalty-free, don't bank on this option unless you've done your research.
3. Annuity fees and commissions can be high
Though no-fee investments are pretty rare, annuities are known to not only charge fees, but also commissions that can be anywhere from 1% to over 10% of your product's value depending on the specifics at hand. As a general rule, the longer your annuity's surrender charge period, the higher your agent's commission will be.
Granted, fees are a common denominator among most retirement savings products. The typical 401(k) plan, for examples, charges a fee equal to roughly 1% of assets for maintenance and administration alone. Furthermore, investments within a 401(k) or IRA generally come with some sort of fee. However, commissions don't usually apply to these savings plans, and you have the ability to limit your fees by choosing lower-cost investments. Annuity fees and commissions are generally less negotiable, so pay attention to what you're being charged.
4. The stronger the company behind your annuity, the safer your investment
An annuity is a contract between you and the insurance company that issues it. If you open an annuity with the wrong company and it runs into financial problems, it could spell trouble for your eventual payments. That's why it's crucial to research annuity companies before funding an account. There are four independent agencies -- A.M. Best, Fitch, Moody's, and Standard & Poor's – that rate the financial strength of insurance companies. Though each has its own ratings scale and criteria, it pays to do a thorough comparison to see which company is the least risky.
Though annuities aren't right for everyone, they could be a good solution for your retirement savings needs. The key is to do your research and know exactly what you're signing up for to avoid unpleasant surprises down the line.
The Motley Fool has a disclosure policy.