Understanding Annuities

In the United States, an annuity is a financial product, typically issued by an insurance company, that provides regular payments to an investor over time—often designed to support retirement savings. These payments usually occur annually and can last for the rest of the annuitant’s life. The annuity owner often serves as the policyholder and the person whose life expectancy determines the contract terms. The owner maintains control over the annuity, including the right to access its cash value, assign it, or make withdrawals. Insurance companies offering annuities distribute payments either immediately (immediate annuities) or after a set accumulation period (deferred annuities). Notably, annuity earnings grow tax-deferred, meaning taxes are paid later when withdrawals begin.

Many individuals use annuities to complement other retirement investments like IRAs, 401(k)s, and pension plans. As contribution limits for traditional retirement accounts are reached, annuities can provide another avenue for tax-deferred growth. They are also useful for diversifying a retirement portfolio. However, annuities aren’t ideal for everyone—personal financial needs and goals should be carefully evaluated, and professional advice is recommended.

There are various types of annuities, including fixed, variable, and tax-advantaged options, each with unique benefits and drawbacks suited to different financial strategies.

Quick Overview: Pros and Cons of Annuities

Advantages

• Tax Benefits: Like IRAs and 401(k)s, deferred annuities allow earnings to grow tax-deferred until withdrawal.

• No Contribution Limits: Unlike retirement accounts, there’s no maximum limit on how much you can invest in an annuity.

• Guaranteed Income: Some annuities offer predictable, steady income, ideal for conservative investors concerned about outliving their savings.

• Financial Management: Structured payments help manage spending, particularly useful for individuals who might overspend a lump sum.

Disadvantages

• Limited Liquidity: Early withdrawals often incur surrender charges from insurers and penalties from the IRS, making annuities less flexible.

• Complex Rules: Annuities come with intricate tax and withdrawal regulations, varying by product.

• High Fees: Sales commissions, administrative costs, and annual fees—especially for variable annuities—can significantly impact returns.

• Moderate Returns: Fixed indexed annuities typically offer modest annual returns (~3.27%), lower than historical stock market averages but with less risk.

Fixed vs. Variable Annuities

Most annuities are either fixed or variable, with a third growing category: indexed annuities.

Fixed Annuities

Fixed annuities promise a guaranteed payout amount based on current market interest rates at the time of signing. Although they offer stability, they often lack cost-of-living adjustments, so purchasing power may decline over time. Fixed annuities are popular among retirees and conservative investors seeking predictable income.
A subset called Multi-Year Guaranteed Annuities (MYGAs) offers a fixed interest rate for a set number of years—similar to Certificates of Deposit (CDs), but with tax-deferred growth and longer terms.

Variable Annuities

With variable annuities, payouts depend on the performance of underlying investments like mutual funds. While offering higher growth potential, they also carry market risk, meaning the principal is not guaranteed. This option suits investors comfortable managing portfolios and tolerating market volatility. However, be aware that variable annuities often have the industry’s highest fees.

Indexed Annuities

Indexed annuities blend features of both fixed and variable products. They provide a guaranteed minimum return with additional gains linked to a stock market index (such as the S&P 500). However, earnings are typically capped, meaning investors don’t capture the full market upside but benefit from built-in protections against losses.

Immediate vs. Deferred Annuities

Choosing between immediate and deferred annuities is crucial based on financial needs and timing.

Immediate Annuities

With an immediate annuity, you make a lump-sum payment and start receiving income almost immediately—typically within a year. Ideal for those entering retirement, immediate annuities provide a predictable income stream without an accumulation phase.

Deferred Annuities

Deferred annuities allow your investment to grow tax-deferred until withdrawals begin, usually at retirement age (59½ or later). Early withdrawals may incur a 10% IRS penalty. They are suited for long-term savers looking to maximize tax-deferred growth beyond the limits of traditional retirement accounts.

Surrendering an Annuity

Canceling an annuity contract—known as surrendering—often triggers surrender charges, especially within the first 5 to 9 years. For example, canceling in the first year could incur an 8% penalty, decreasing each year thereafter. Free-look periods (typically 10–30 days after purchase) allow annuity holders to cancel without penalties. Be aware that early withdrawals may also lead to additional IRS penalties.

Understanding Annuity Fees

Annuities come with several types of fees, often expressed as basis points (100 basis points = 1%).

• Surrender Charges: Penalties for early withdrawals, generally declining over time.

• Administrative Fees: Cover administrative costs, usually between 0.10% and 0.30% annually.

• Sales Commissions: Vary based on the annuity type—ranging from 1% to 10%.

• Investment Management Fees: Applicable mainly to variable annuities to cover fund management.

• Mortality and Expense Fees: Insurance charges for providing lifetime income and death benefits, usually 0.40%–1.75% annually.

• Rider Charges: Optional features, like guaranteed income riders or inflation protection, come with additional costs.

Rolling Over 401(k) or IRA Into an Annuity

You can roll over retirement accounts such as 401(k)s and IRAs into an annuity without triggering immediate taxes, creating a qualified annuity funded with pre-tax dollars. Key points to remember:

• Rollovers must be reported on your tax return.

• Only one IRA-to-IRA rollover is allowed per year.

• Complete the rollover within 60 days to avoid taxes and penalties.

Annuities can transform your retirement savings into predictable, guaranteed income, offering a safety net for your financial future.