What Is an Annuity: Types, Rates, and Tax Implications

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Do you ever worry that you may outlive your savings in retirement? With rising cost of living, and increasing rates of inflation, it’s more understandable than ever to be unsure of just how far one’s retirement savings can be stretched. The prospect of running out of adequate savings towards the end of one’s life can be daunting. An annuity is a type of insurance that can help protect you from just such a situation. 

There are several different kinds of annuities that each have their own sets of pros and cons. For some, in certain financial situations, an annuity may offer helpful peace of mind. But for others, annuities may be a bad deal wrapped up with a bow on top. After all, annuity companies are here to make money, just like any other company. Join us to look at annuities; what they are, the forms they take, and how they work, in order to understand if they are actually as good of a deal as they promise to be.

What Is an Annuity and How Does It Work?

An annuity is a financial product that you can purchase in exchange for a guaranteed income in the future. Annuities are sold by companies such as banks, insurance companies, and even some investment brokers. When you sign up for an annuity, you begin making payments during what’s known as the accumulation phase. In exchange, the company will someday begin making regular payments back to you during what’s known as the distribution phase. 

Annuities come in all shapes and sizes, so it’s possible to select one with a distribution phase of as little as 10 years to as long as for the rest of your life. If you select the latter, you can enjoy the security of knowing that you’ll always have a guaranteed source of income, so you aren’t forced to rely on things like savings, a 401(k), or social security.   

Immediate vs. Deferred Annuities 

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So, how do you purchase an annuity? The first thing you might consider is the timeline on which you want to begin to receive payments. In this instance, you would need to choose between an immediate annuity and a deferred annuity. 

If you want to begin receiving payouts within a year, an immediate annuity is the type of annuity for you. Immediate annuities are typically purchased with a large lump sum and are often funded by a retirement account like a 401(k). If you’ve acquired a large sum of cash, such as an inheritance or large investment payout, funneling that into an immediate annuity can be a good way to assure that you’ll enjoy access to this money, distributed back to you over time with interest. 

However, if you don’t have a large amount of money to put towards an annuity immediately, and if you don’t foresee a need for payouts in the coming years, you might consider opting for a deferred annuity. A deferred annuity won’t begin paying out until the future, usually after retiring. By starting early, you allow your money more time to grow on a tax-deferred basis and decide later on how long of a payment period you want to enjoy. 

Since a wide range of different companies offer annuities, their minimum initial investments, fees, and other terms can vary widely. Additionally, there are plenty of different types to choose from, but most are some form of one of three main types. Broadly speaking, annuities usually fall under the categories of a fixed annuity, variable annuity, or index annuity. 

What Is a Fixed Annuity?

If you’re looking to take no chances, then a fixed annuity is the lowest-risk way to go. Fixed annuity contracts are the most predictable because they offer a fixed interest rate so that market volatility won’t affect your payments. Some fixed annuities even offer two separate internet rates: a minimum interest rate guaranteed for the life of the contract and another set for a particular period of time. At the end of the time period specified for the latter, the company will then declare a renewal rate that’s good for the next set length of time. 

This means that there’s a chance of your rate increasing if the market is on an upswing, but no chance of it ever going below the lifetime guaranteed rate. Like most other low-risk investments, the pro of a fixed annuity lies in its predictability, while the con is that you may potentially miss out on larger payments during stronger market periods.  

What Are Variable and Index Annuities?

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A variable annuity is a higher-risk option but also offers the possibility of a higher reward. When you purchase a variable annuity, you can choose from various stocks, bonds, mutual funds, and other investments to put your money into. While you’ll still receive predictable payments with a variable annuity, the amount of each will differ depending on the performance of the investment products you’ve chosen. 

As the name suggests, your income payments will always vary. The obvious disadvantage of going this route is that it can make financial planning harder, especially if you end up relying on your annuity payments as a primary form of income. The upside is that if your underlying investments do well, you can benefit from higher payouts.  

If you’re looking for a middle ground, you might look into index annuities. While they offer a minimum guaranteed interest rate, they also provide a separate variable interest rate that tracks the performance of a market index like the S&P 500. The perk of these medium-risk annuities is that they typically come with a specified cap on how much you can earn or lose in a given year. They tend to be a good mix of predictability and opportunity for increased payments. 

Tax Implications of Annuities

Similar to IRAs, different types of annuities come with different tax implications. The good news is that your investment will be allowed to grow on a tax-deferred basis until you begin receiving payments. At that point, whether or not your payments are considered taxable income will depend on whether you invested with pre- or post-taxed funds.  

If you purchased your contract with pre-taxed funds, your payments would count as taxable income. If you purchased it with post-taxed funds, you’d only be required to pay taxes on any earnings you may have received. Annuity tax implications can get complicated quickly, so be sure to speak with your financial advisor to make sure you understand what you may or may not owe down the line. 

Pros and Cons of Annuities 

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As with any other investment, annuities come with their own sets of pros and cons. While purchasing an annuity may be a solid plan for one investor, this strategy isn’t for everybody. 

Some of the pros of annuities include a guaranteed lifetime income with predictable payments and protection from market volatility . Most annuities have no annual contribution limits. And annuities can offer great peace of mind to those who have maxed out their retirement plans. 

Still, there are significant drawbacks to annuities. Most come with hefty early withdrawal fees, and if most of your money is squirreled away in an annuity at a time when you need liquid income, you could end up taking a big hit to recoup even some of that money. Annuities don’t always stack up to other options, like IRAs and retirement plans, that tend to offer lower fees and better tax benefits. Additionally, annuities that have fixed payouts will not be responsive to factors such as inflation, which can Finally, it’s important to remember that commission-based annuity agents do not necessarily have your best interest at heart. Annuities serve you best when you live beyond your life expectancy and can reap the benefits of the annuity beyond what you paid into it. This is also the circumstance in which annuity lenders take a hit, and some have suggested that annuity issuers may try to sell annuities to individuals who are less likely to live into old age. Talking to a financial advisor that you trust with your own best interests can be helpful when deciding what sort of investment is best for you to support you through retirement.