Annuities are products that can be used to help you increase your savings, protect what you’ve saved or generate a stream of income. Annuities, which are sold by insurance companies, generally fall into two distinct categories: Deferred and income. Under deferred and income categories there are 3 basic types of annuities: Fixed, Fixed Indexed and Variable. (See Below)
Each works differently and offers a unique set of advantages. Here are some guidelines to help:
Deferred Annuities:
Deferred annuities can be a good way to increase your retirement savings once you’ve made the maximum allowable contributions to your 401(k) or IRA. Like any tax-deferred investment, any earnings compound over time, and you do not pay taxes on any gains until the funds are withdrawn. This can provide compounding opportunities not available in taxable accounts. Bear in mind that any gains will be taxed as ordinary income when funds are withdrawn. Also, remember that variable deferred annuities come with additional expenses not found in mutual funds, which will impact your returns.
Deferred annuities have no IRS contribution limits, so you can invest as much as you want for retirement. You can also use your savings to create a guaranteed stream of income for retirement.
Deferred Annuities Can Either Be Variable or Fixed.
Variable deferred annuities contain investment options which allow a contract owner to take advantage of potential growth opportunities. However, this approach does involve some market risk and could lead to losses if the value of the underlying investments falls. Variable annuities are usually appropriate for those with longer time horizons and thus better able to handle the market’s fluctuations.
Assets in a fixed deferred annuity offer a guaranteed rate of return for a number of years. Fixed deferred annuities may be more suitable for conservative investors or for those who are closer to retirement and want to protect their assets from market volatility. In this way they’re similar to a CD. Unlike CDs though, annuities are not FDIC insured. Also, any funds withdrawn from any annuity prior to age 59½ may be subject to a 10% IRS penalty. However, annuities may offer more access to assets than a CD and, unlike a CD, earnings compound on a tax-deferred basis.
Income Annuities: For Immediate Income
Income annuities may be appropriate for investors in or near retirement because they offer guaranteed income for life or for a set period of time. By creating a lifetime income stream, an income annuity may also allow you to be more aggressive with other investments in your portfolio. Bear in mind that you may have no or limited access to assets used to purchase income annuities.
Like Deferred Annuities, Income Annuities Can Be Variable or Fixed.
A variable income annuity offers an income stream that includes growth potential that may help keep pace with inflation. This income is guaranteed for life, but the amount of each income payment is not guaranteed—the payment amount will vary based on the performance of the annuity’s underlying investments.
A fixed income annuity offers a guaranteed, predictable payment for life, or for a certain period of time. Your guaranteed income payment cannot be affected by market volatility, which helps to shield your retirement income from market risk. A cost of living increase is also available at an additional cost on some products to help your buying power keep pace with inflation.
Living Benefit Annuities: For Generating Income
Many people nearing or in retirement are looking to establish an income stream for the long term while continuing to participate in the market. Deferred variable annuities with guaranteed living benefits, such as those that offer a guaranteed lifetime withdrawal benefit, provide both guaranteed lifetime income and growth potential and may also offer access to assets. These “hybrid” annuities can provide a lifetime guaranteed income stream for you or for you and your spouse. The income payments these annuities provide will not be reduced by poor market performance, even if the performance results in the contract value declining. In fact, if the account’s investments perform well, the income payments may increase. Those increases are also protected from subsequent market declines.
Different types of annuities work differently. Which one may be suitable for you depends on your individual needs and goals. A financial professional can help you determine which annuity may be right for you.
Fixed annuities:
- You give the insurance company money in one or more payments.
- The insurance company places the money in its general account and then invests it on behalf of all annuity owners.
- Later, the insurance company credits your annuity with interest under the terms of your contract, while offering protection from loss of principal.
- Any interest growth in your annuity will be tax-deferred, and after a period of time specified by your contract, you may then receive the amount allowed by your contract in a lump sum, over a set period of time, or as income for the rest of your life.
Fixed index annuities:
- You give the insurance company money in one or more payments.
- The insurance company places the money in its general account and then invests it on behalf of all annuity owners.
- Later, the insurance company may credit your annuity with interest based on positive changes in an external index of your choice, such as the S&P 500, while offering protection from loss of principal. Some fixed index annuities let you choose from a number of available index options, while others may offer limited choices. Because fixed index annuities are fixed insurance products, at no time is your contract’s value invested directly in the stock market.
- Any interest growth in your annuity will be tax-deferred, and after a period of time specified by your contract you may then receive the amount allowed by your contract in a lump sum, over a set period of time, or as income for the rest of your life.
Variable annuities:
- You give the insurance company money in one or more payments.
- The insurance company lets you choose from a variety of investment options. Some variable annuities let you choose from a number of variable investment options, while others offer a pre-determined mix of investments.
- Over time, your contract’s value may increase – or decrease – depending on the performance of the investments you choose. Variable annuities involve risk, and it is possible to lose money.
- Any growth in your annuity will be tax-deferred, and after a period of time specified by your contract you may then receive the amount allowed by your contract in a lump sum, over a set period of time, or as income for the rest of your life.
Keep in mind that if you withdraw money earlier – or in a greater amount – than your contract allows, fees and penalties may apply, including a 10% federal penalty for withdrawals prior to age 59½. All distributions are also subject to ordinary income tax.