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The Pros and Cons of Buying an Annuity For Retirement

April 15, 2024

6 min Read

Written by Vance Cariaga

Edited by Melanie Grafil

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Most Americans build retirement savings through individual retirement accounts or employer-sponsored plans such as 401(k)s. But another option is an annuity, which is designed to provide a steady source of income throughout your retirement.

You have a few different choices when it comes to choosing the right annuity for your purposes. Keep reading to learn more.

What Is an Annuity?

The Securities and Exchange Commission describes an annuity as a “contract between you and an insurance company that is designed to meet retirement and other long-range goals.” How should you fund an annuity? You can start with a lump-sum payment, or opt for installment payments. Your annuity insurer will then issue payments, either at the beginning of the term or on a different date.

One advantage of an annuity is that it offers tax-deferred earnings growth. In some cases, you might also get a death benefit that pays beneficiaries a specified minimum amount, such as your total purchase payments. Once you start making withdrawals from the annuity, any gains are taxed at the ordinary income rate.

An important thing to keep in mind is that if you withdraw your money early from an annuity, you could face surrender charges to the insurance company as well as tax penalties.

Here are the three basic types of annuities:

Fixed: With a fixed annuity, the insurer agrees to pay you a set interest rate during the period when your investment is still growing. The insurer will also makes periodic payments of a specific dollar amount. The payments can cover a pre-determined period, such as 20 years, or an indefinite period such as your lifetime or the lifetime of you and your spouse.
Variable: A variable annuity lets you choose how to invest the money you put into the account. These investments typically involve mutual funds, and the rate of return depends on the performance of the funds. The main risk with a variable annuity is that you could lose money.
Indexed: In an indexed annuity, your return is based on changes in market indexes such as the S&P 500 Composite Stock Price Index.

Variable annuities are regulated by the SEC. Some indexed annuities might be regulated by the SEC, but no fixed annuities are. Regardless of the type of annuity, your funds are not protected by the Federal Deposit Insurance Corporation or any other agency.

How an Annuity Works

The first thing you need to understand about an annuity is that it’s a contract between up to four parties:

Owner: This is the person who buys the annuity.
Annuitant: The annuitant is the one who gets the benefit payments and is often the same as the owner.
Beneficiary: The beneficiary receives death benefits payable under the annuity contract, if applicable.
Issuer: The issuer is the company that issues the annuity, usually an insurance firm, and pays benefits when the time comes.

The next thing to know is that annuities are divided into two phases. Here’s a look at each:

Accumulation phase: Sometimes called the investment phase, this is the period when you make contributions to account and your funds grow.
Payout phase: In the payout (or annuitization) phase, you start getting payouts from your earlier purchases. Payments can be in a lump sum, via periodic payments or a combination of the two. The payout amount is determined by the amount you paid in, the investment performance, your expected lifespan and the type of distribution you chose.

Pros and Cons of an Annuity for Retirement

Annuities are like any other investment in that they have both pros and cons. Here’s a rundown:

Pros

Contributions are tax-deferred. With an annuity, you won’t owe taxes on the money until you start getting payments. This means your contributions have a chance to grow tax-free, similar to a 401(k).
Regular payouts: One of the main advantages of an annuity is that it is set up to provide monthly payments during retirement, which guarantees income over a certain number of years.
Guaranteed rates of return for fixed annuities: Fixed annuities pose little financial risk because your interest rate is locked in, meaning you are guaranteed a payment during the payout phase.
Death benefit: You will typically get a standard death benefit with most annuities. This means your heirs will receive a payout if you pass away before taking withdrawals.

Cons

Fees: You will face fees with an annuity that vary by the issuing company. Fees are typically anywhere from 1% to 3% of your account balance per year. Most issuers will also charge other fees, such as early withdrawal fees or fees for optional riders.
No federal protection: The money in your annuity is not guaranteed by the FDIC, Securities Investor Protection Corporation or any other federal agency.
Potential for losses: This mainly applies to variable annuities, which don’t have guaranteed rates of return and instead depend on the performance of underlying investments to earn money. If the performance is negative, you could lose money.
Early withdrawal penalties: If you withdraw money early from the annuity, you could face surrender charges and tax penalties.

Who Should Use an Annuity?

The main purpose of an annuity is to remove longevity risk for retirees, meaning you don’t have to worry about outliving your retirement savings. This is an especially important consideration given that people are living longer now.

An annuity is an especially good option for those who are approaching retirement age, are expected to live a long time, and have a decent nest egg saved up. It might not be a great fit if you don’t have much retirement savings because there is some risk involved.

Final Take

Annuities offer a tax-deferred way to grow your retirement savings and can be a great option for guaranteeing a source of monthly income in your golden years. Depending on the type of annuity, however, you could face hefty fees and potential losses. Read the fine print before signing an annuity contract–you’ll want to make sure you know exactly what to expect.

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