Saving for retirement can be daunting. Even with careful planning and regularly contributing to the best retirement plans, the amount of money you need to save to maintain your desired lifestyle during retirement is uncertain.
That's where annuities come in. Annuities can be a valuable tool in retirement planning. By combining insurance and investment elements, annuities provide a guaranteed income stream to help you avoid the risk of outliving your savings.
Introduction to deferred annuities
A deferred annuity is an investment you buy in exchange for periodic payouts later on, typically during retirement. It's purchased from select insurance companies, banks, brokerage firms, and mutual fund companies.
"You generally put a lump sum or multiple payments into an account with an insurance company, and you make a contract with them," says Jordan Gilberti, financial planner and senior lead planner at Facet. "The promise is that they're going to pay you a certain amount. It could be a lifetime benefit or a 10-year benefit."
How deferred annuities work
To get a deferred annuity, you'll need to pay a premium — usually a large lump sum — and then the insurer invests it. Afterward, the insurer provides you with a stream of payouts for a predetermined number of years or even the remainder of your lifetime.
An annuity has two phases:
- The accumulation phase: An annuity's accumulation phase is when you're making payments. Those funds may be split among various investment options.
- The annuitization phase: The annuitization phase is when you receive payouts from the annuity, much like a regular paycheck. This can last for a set amount of years or the rest of your life. The payouts include the principal amount along with any investment gains.
Annuities provide a stable investment option for savers who worry about market volatility or outliving their retirement savings.
Types of deferred annuities
Different types of annuities vary in how your money is invested and the level of risk involved.
Fixed annuities
Fixed annuities place your money in a general account (often through an insurance provider), which promises a minimum interest rate and a fixed amount of periodic payouts. The premiums for fixed annuities are invested in high-quality, low-risk fixed securities such as bonds.
Although fixed securities pose less risk than more volatile stocks or mutual funds, you won't generate as many gains as you would with a variable annuity. However, most fixed annuities do include a guaranteed minimum interest rate.
Before investing in a fixed annuity, ensure that your state insurance commission confirms that your insurance broker, bank, or lender is registered to sell fixed annuities.
Variable annuities
Variable annuities place your money in various investments, much like a 401(k), and are directly linked to the stock market's performance.
The payouts from variable annuities fluctuate depending on how much money you pay, the rate of return on your investments, and any expenses of those investments. Although you'll be at more risk of losing your money, variable annuities offer a greater return potential.
You can divvy your premium into multiple subaccounts to invest in different market sectors. Variable annuity funds can be invested in stocks, bonds, mutual funds, and money market funds and are regulated by the Securities and Exchange Commission (SEC).
Indexed annuities
Indexed annuities provide the positive investment potential that variable annuities offer. Their return is based on a stock market index, like the S&P 500. Like fixed annuities, index annuities are regulated by state insurance commissioners.
Just like with a variable annuity, indexed annuities often have complex and hefty fees, such as surrender fees (also referred to as surrender charges) imposed on policyholders if they cancel.
Benefits of annuities
At their core, annuities are full of advantages.
Tax-deferred growth
Annuities are tax-deferred, meaning you won't pay taxes on the initial contribution or the investment gains until you withdraw. Remember, however, that if you decide to purchase your annuity with after-tax dollars, you'll pay tax on the investment gains when you receive payouts.
One of the best perks of investing in annuities is how it is taxed. "Annuities complement other retirement plans in that they provide opportunities to grow without heavy taxation," says Rob Williams, CFP and managing director at Charles Schwab.
Guaranteed lifetime income
Once you've made your payments, you're guaranteed to receive payouts for a set period, maybe even the rest of your life. This is especially handy for retirees concerned they haven't saved enough for retirement and are seeking reliable income that can significantly reduce financial stress.
Protection from market volatility
Annuities can help diversify your retirement savings and decrease market risk and volatility. However, some annuities may include market-linked features. Carefully review your annuity contract to ensure it aligns with your risk tolerance and goals.
Death benefit
You may be able to designate a beneficiary on your annuity. After the original owner passes, the beneficiary will receive a fixed amount or the remainder of the annuity contract. Beneficiaries typically aren't taxed on the principal amount; only the earnings are considered income.
Beneficiaries of annuities should contact a financial planner or tax consultant for further advice and guidance.
Drawbacks of deferred annuities
"Typical annuities have some disadvantages, like a lack of flexibility, lack of investment options, and a lot of times you have to make the tradeoff of getting potentially higher returns to get those guaranteed payments," says Gilberti.
High fees
Annuities typically have high fees and commissions, which can reduce long-term earning potential. Because of this, annuities aren't a great place to grow money, but fixed immediate annuities take a smaller fee hit while generating a lifetime income stream.
Taxable income
Annuities aren't totally tax-free. As a source of income, annuity payouts are subject to income tax as you receive them. If you withdraw from your annuity before 59 ½, you'll also face a 10% penalty on top of your ordinary income tax.
Payouts are also subject to your regular income tax rate. If you're living in a high-tax state like California or New York, you may benefit from deferring some of your income and moving to a lower-tax or tax-free state to pay less in income tax later on.
Limited liquidity
Variable annuities have limited liquidity and don't offer access to your money until after several years — typically six to eight, but sometimes longer.
Suppose you withdraw funds or cancel your annuity contract before that surrender period ends. In that case, you incur a surrender fee that can initially reach as high as 10% of your contributed funds, decreasing by one percentage point each consecutive year. Once your payouts start, changing them or accessing more of your principal is next to impossible.
Annuity fees
In addition to your premium payments, you'll likely face some fees. Annuity fees typically range between 1% and 3%. An annuity with fees on the higher end of that range may not be a solid investment as they can take a hefty chunk out of your earnings.
- Mortality and expense risk charges compensate the annuity issuer for the risk it takes to offer the annuity. This charge equals a percentage of your annual account value, often around 1.25% annually.
- Administrative fees cover the cost of record keeping and managing your annuity. They can be charged as a flat annual fee or a percentage of your account value.
- Commission fees often contribute to an annuity's price and exist to pay the person who sold it to you. This may drive an annuity's price up. You can likely avoid annuity commissions by buying from a fiduciary advisor, as they don't earn commissions. Fiduciaries usually charge by assets under management (AUM) or are fee-only.
- Fund expenses are the costs that come with the funds your annuity may invest in, like mutual funds.
- Additional feature fees include optional features you can add to your annuity, such as guaranteed minimum income benefit or long-term care insurance.
- Penalties apply if you withdraw from an annuity before you're 59½. The Internal Revenue Service will levy a 10% tax penalty on top of the regular income taxes you owe for the withdrawal amount.
- Surrender charges apply to variable annuities when you sell or withdraw money during the annuity's surrender period, often six to eight years after buying the annuity. Early withdrawals may trigger unexpected tax hits, making variable annuities better for long-term goals.
Who should consider a deferred annuity?
You should consider a deferred annuity if you are:
- Seeking guaranteed retirement income: Annuities can be a great way to supplement your savings by investing after retirement, along with Social Security payments. Fixed annuities also avoid the ups and downs of market investing. Annuities may be good investment options for retirees worried they'll spend their savings too quickly.
- A risk-averse investor: While not an ideal investment product to build wealth, annuities do have the potential to accrue value when invested in securities like fixed-rate bonds or variable money market funds.
- Maxing out other retirement accounts: Annuities are a suitable addition to your retirement savings plan if you're always maxing out your 401(k) contributions and can afford the fees. They provide steady income throughout your retirement, grow tax-free (until you receive payouts), and your beneficiaries can benefit from the payouts, too.
Younger individuals saving for retirement or paying down debt shouldn't buy an annuity, as annuities are better for older folks nearing retirement. Rather than purchasing an annuity, you can contribute a portion of your monthly income to tax-advantaged retirement savings accounts like 401(k)s and IRAs to benefit from compound interest and additional investment gains.
Since annuities aren't free, however, weigh their costs against their promised benefits to determine the right choice for you.
What is an immediate annuity?
Immediate annuities, or single premium immediate annuities (SPIA), pay right out of the gate in as short as a month. They are typically purchased as a one-time lump sum. The insurance company then calculates the amount due based on age, prevailing interest rates, and how long the payouts are expected to continue.
It's your call if you want an income stream for a limited period or a lifetime and monthly, quarterly, or yearly payouts. In general, the amount you receive for the whole period of your contract is fixed and guaranteed.
FAQs for deferred annuities
How are deferred annuities taxed?
Deferred annuities are taxed as income when receiving payments, offering the benefit of tax-deferred growth. If your annuity was funded with after-tax dollars, you'll only pay taxes on the investment gains when accepting payments.
What are the fees associated with deferred annuities?
The fees associated with deferred annuities are generally higher than those associated with other investment options, which can eat away at potential gains. Annuity fees include administrative costs, commission fees, fund expenses, and a mortality and expense risk charge.
Can I withdraw money from my deferred annuity before the annuitization date?
Technically, you can withdraw money from a deferred annuity before the annuitization date. However, you will be subject to additional fees and penalties. Regardless of age, taking money out of your annuity before the annuitization date results in a surrender charge on the amount withdrawn. If you're younger than 59½, you will be charged an additional 10% penalty fee from the IRS.
