What Is An Annuity?
From their humble beginnings, annuities provided secure monthly payments to an annuity holder, usually for life. These secure payments were in turn for the annuity holder irrevocably giving the insurance company a lump sum of money to manage and invest. They worked but consumers were not always happy with losing access to their money and having limited opportunities for the growth of their assets.
Fortunately, annuities, just like all financial products, have evolved over time.
Today’s annuities are much more agile and designed to meet the changing needs of consumers who desire more options and control. Policies that once offered limited features now offer many choices for growth, income, liquidity and even the opportunity to participate in market growth without the risk of market loss.
Why Are Annuities Important?
Annuities are the backbone of any sound retirement plan. Several popular income planning approaches use annuities as a “Floor” to guarantee essential expenses are covered in retirement. In fact, this is called the “Flooring” approach. Annuities ensure if the worst were to occur, at a minimum, your essential expenses are covered. There is much more annuities can do than this but ensuring expenses are covered and that you will not run out of money during retirement is why annuities are so crucial to your retirement plan.
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Annuities Can Provide For Growth Or Income (Or Both)
Annuities can be broken into two main categories depending on the needs of the annuitant (purchaser):
- Growth of assets
- Annuities focused on growth allow an annuitant to grow their contributions tax-deferred for a set period of time. At the end of the period, the funds in the annuity usually are annuitized resulting in lifetime guaranteed income. In some cases, the funds can be redeployed into other financial vehicles if the annuitant wishes to do something different than create a lifetime annuity.
- Income for life
- Annuities focused on income allow an annuitant to create strategies for maximizing guaranteed lifetime income. Usually these are immediate annuities and began shortly after the contract is created.
Within these two categories there are different types of annuities to consider.
What Are The Different Types Of Annuities?
- Fixed Annuity
- A traditional type of annuity where the principal and the rate of return is guaranteed by the insurance company. These annuities are very similar to bank CDs and offer protection against market volatility. Fixed annuities can be either immediate or deferred if income is desired. Interest earned is tax deferred until income payments begin.
- Index Annuity
- A newer type of annuity that provides the opportunity for tax-deferred growth based in part on changes in a chosen market index while protecting your principal from market volatility. Index annuities enjoy the benefits of participating in market growth while protecting principal when the market declines. Additionally, most policies offer a guaranteed minimum interest credit. Index annuities can be either immediate or deferred.
- Variable Annuity
- Provides the opportunity for tax deferred growth based on direct market performance. A variable annuity is linked directly to the market and assets are wrapped typically in mutual funds or similar vehicles for investment growth. Variable annuities are subject to potential gains or loss depending on the performance of the market.
Yes. One of the biggest advantages annuities offer is they offer tax-deferred growth of savings. And unlike other tax-deferred retirement accounts such as 401(k)s and IRAs, there is no annual contribution limit for an annuity. That allows you to put away more money for retirement and is particularly useful for those that are closest to retirement age and need to catch up. The money you invest compounds year after year without any tax bill from Uncle Sam. The ability to keep every dollar invested working for you can be a big advantage over taxable investments. When you cash out, you can choose to take a lump-sum payment from your annuity, but many retirees prefer to set up guaranteed payments for a specific length of time or the rest of your life, providing a steady stream of income. The annuity serves as a complement to other retirement income sources, such as Social Security and pension plans.
Another advantage is the ability to use annuity funds penalty free for chronic or terminal illness expenses.
Annuities also offer peace of mind. This is hard to quantify but knowing you cannot outlive your money as well as having a consistent paycheck in retirement truly adds to feeling secure and sleeping well art night!
Not all annuities are created equal. Variable annuities may contain high fees that are paid year after year.
You may likely face a surrender charge for pulling money out of an annuity within the first several years after you buy it. The fee generally declines by one percentage point a year until it gets to zero after year seven or eight years. If you think you will need access to your funds short term, it may be better to wait to invest in an annuity. Like with all saving programs, you need to be able to let it sit and grow. With that said, many new policies have features that allow for penalty free withdrawals each year to offer some degree of liquidity.
Yes. Money that you invest in an annuity grows tax-deferred. When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your earnings are taxed at your regular income tax rate.