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What Is an Annuity?

Annuities allow you to create an extra income stream during retirement. Find out how they work and why they can be beneficial.

When you’re planning for retirement, there are a variety of financial tools to choose from. One that you’ll often see is an annuity. After investing in one ahead of retirement, either upfront or via monthly payments, you’ll receive an income for a set amount of time.

An annuity is a useful retirement vehicle that grants you additional income. In this article, we’ll teach you how they work, the types you can choose from, and the pros and cons. After reading, you’ll have a better idea of whether investing in one is right for you.

How Annuities Work

An annuity is a long-term contract between you and an insurance company, where you make a payment (or a series of them), then they’ll pay you either now or later. Much like how you pay, you can opt to receive your payments all at once or incrementally.

Annuities are a way to set up income during your retirement years. But they can also be beneficial for other reasons, such as when you have a large windfall. Setting them up, while seemingly complicated at first, is relatively simple. It typically includes three steps:

  1. Selecting your annuity type. You’ll need to choose the optimal one for you (which we’ll expand upon later). This dictates how the insurance company invests your funds, affecting your returns.
  2. Accumulation phase. This is where you’ll pay into your annuity. Once you’ve done so, the insurer or financial institution you work with will invest the funds based on the type you selected earlier.
  3. Annuitization phase. This is where you’ll start receiving payments. Your income consists of your original investment, plus any returns. Keep in mind that you may have to pay fees or, in some cases, income taxes.

Note: you may elect to receive annuity payments immediately or defer them for a later date, usually for retirement. Often, those who decide to receive immediate payments have recently received a windfall, such as a settlement, inheritance, or from winning the lottery.

How You’ll Receive Payments

Once it’s time, you’ll be able to receive payments from your annuity in several different ways. Below is a breakdown of the most common methods (the options available to you may differ depending on the company):

  • All at once (lump sum). In this case, you’ll receive your entire annuity investment in one payout. Keep in mind that it’ll be subject to income taxes.
  • Death benefit. In the event of your passing, before annuity payments start, the financial institution will make an additional payment to your beneficiary.
  • Fixed amount and period. Here, you’ll choose how much and how often you get paid. For instance, you may opt to receive payments for 15 years at $2,000 per month. This will continue until your investment runs out or the period ends, whichever comes first.
  • Joint and survivor life. With this, you and your surviving spouse will receive payments for the rest of your lives.
  • Life only. This guarantees income from your annuity for the rest of your life. But, after you pass, nobody else will receive payments.
  • Life with period certain. This carries the same rules as life only, but you’ll also be able to set a specific term for payments to continue. So, if you have beneficiaries, they’ll receive money after your death until the term expires.

Tax Considerations

Like other financial vehicles, such as 401(k)s and Roth IRAs, annuities have special tax considerations. When you make your initial investment, future growth based on interest is tax-deferred, meaning you won’t pay until you withdraw your money.

How you pay taxes depends on the type of account you have. A qualified annuity means you must treat withdrawals as ordinary income for tax purposes. However, with a non-qualified annuity, you’ll only need to pay for the growth of your initial investment.

Types of Annuities

There are several types of annuities from which you can choose. Each one decides how you’ll receive income and the investment of the funds within it. To get the outcome you want, selecting the right one is crucial. Here are the main types you’ll find:

  • Immediate annuity. As soon as you pay into it, you’ll begin getting payments. You can choose to receive money for a set period, or the rest of your life.
  • Deferred annuity. With this type, you won’t start receiving payments until a set date, such as at your retirement.
  • Fixed annuity. If you choose this option, you’ll receive a payment equal to the amount you agree upon ahead of time. Your investment will also earn based on a guaranteed rate of interest.
  • Variable annuity. In this case, you’ll take on more risk, but potentially for higher rewards. Your initial investment will be allocated to any combination of stocks, bonds, mutual funds, etc. The payments you receive will depend largely on how well your portfolio performs. 
  • Indexed annuity. Your investment’s return follows a stock market index, such as the S&P 500. So, when the market performs well, your investment will grow. However, it may lose value, often temporarily, if there’s a slump.

Pros and Cons

Investing in an annuity is an attractive option for people to create a guaranteed income source as they retire. It may also be a smart way to spread out large lump sum payments, such as lottery winnings or settlements. Here are the advantages of investing in one:

  • Ability to extend payments out for your lifespan and potentially beyond.
  • Chance to create guaranteed income.
  • Depending on your contract, beneficiaries may be able to receive payments.
  • Opportunity for diversification and additional investment options
  • You can defer taxes on investment growth.

However, much like any investment, an annuity doesn’t come without its downsides, such as:

  • Contractual restrictions (i.e., you’re at the mercy of the firm you’re working with and your contract’s rules).
  • Lack of liquidity because you can’t take funds out early without penalty.
  • Limited growth potential due to low-risk investments.
  • You’re subject to fees, such as for investment management and commissions.

How to Decide If It’s Right for You

Annuities are useful tools, but they’re not right for everybody. Ultimately, deciding to get one depends on your current financial situation and retirement plans, if any. They’re ideal for retirement if you’ve already maxed out tax-advantaged savings accounts, such as a 401(k) or Roth IRA, and would like another income source. Winning the lottery, receiving large settlements or inheritances, or simply wanting to create a new income stream are also reasons to invest in one.

As mentioned in the last section, annuities have some disadvantages to consider. They’re not a very liquid investment, meaning you’ll have to accept that you often won’t be able to touch the money for years without penalty. You’ll also be subject to fees, including for investment management as with a mutual fund. Additionally, they’re relatively low risk, so you won’t typically see any crazy returns on investment (ROI). If you’re looking for a bigger ROI or want to avoid expensive fees, you may want to steer clear of annuities for now.

If you still have questions about whether to buy one, you should think about speaking with a financial advisor. They can help you determine the best ways to maximize your ROI, whether it be with an annuity or another type of investment. To find one, consider using this free matching tool that connects you with up to three vetted professionals in your area.

Life Insurance vs. Annuities

Life insurance and annuities have similar features, but they’re completely different vehicles. With the former, your beneficiaries will receive one lump sum payment. With the latter, however, you can opt to start receiving payments before you pass, either monthly or all at once. It’ll also come with a death benefit if your contract includes one.

Term life insurance policies, which pay dependents after you’re gone, are not tax-deferred (though whole-life policies are). Annuities, on the other hand, often accumulate interest tax-deferred, allowing you to keep more money.

Frequently Asked Questions

Who needs an annuity?

Annuities may be smart investments for those looking to add an extra income source for retirement. They’re also a good way to space out payments after a large payout, such as lottery winnings or a cash settlement.

What is the biggest disadvantage of an annuity?

The most prominent is that you’ll have to pay substantial fees. You’re also at the mercy of your contract and how well the insurer manages your investment. Finally, you’ll usually have to wait to take your money out without penalty.

Are annuities good for retirement?

In many cases, yes. They allow you to create income for yourself during your later years. You can also set one up so it pays out to your beneficiaries after you pass away, much like a life insurance policy.