Annuities can be incredibly beneficial retirement income planning vehicles because of the advantages they offer over other savings and investment chassis. From tax deferral on earnings to guaranteed income and growth over time, annuities have the potential to meet several retirement needs in one shot. However, they are also one of the most complex vehicles available. Not only are annuities offered by several different companies, but they also come in different types, with a variety of features, and widely ranging terms and restrictions.
Given these complexities, it’s a challenge to know when purchasing an annuity is ideal for your situation.
Recognizing what annuities can offer – and what they do not – is vital in making the annuity purchase decision. Here are a few scenarios in which utilizing an annuity vehicle may make the most sense.
When You Don’t Need Liquidity
There are very few annuity options offered with full liquidity, meaning you are not able to withdrawal funds like you could in a conventional brokerage (investment) account or a savings vehicle. Instead, annuities have surrender schedules, ranging from five to 10 years in most cases. If you need to withdraw funds, you have one of two options: take out up to the free withdraw provision, usually 10% of the contract’s value, or have a portion of your funds withheld as a penalty for an early withdraw.
Also, all annuities, whether fixed, indexed, or variable, operate as a retirement account in terms of age-based restrictions. Just like an individual retirement account or an employer-sponsored plan like a 401(k), money cannot be withdrawn without a penalty before age 59 ½. If it is, you are subject to a 10% early withdraw penalty unless specific requirements are met. The combination of the surrender schedule and the age-based limitations of annuities mean they aren’t always suitable for those who need quick access to their funds. However, when you do not need liquidity because other investment and savings vehicles are in place and accessible, an annuity may be a beneficial addition to your retirement income plan.
When You Want a Guarantee of Principal
One of the features of many annuities is the promise your account value won’t go backward. Having a guarantee of principal, or the amount of money paid as the initial premium, offers peace of mind you cannot achieve with other, non-guaranteed investment vehicles. This may come by way of a fixed interest rate in a fixed annuity, or downside protection in an indexed or variable annuity. Also, the insurance companies offering annuities are required to have a certain amount of money in reserves, typically enough to cover the contract premiums they guarantee. If you’re concerned about your account value moving in a negative direction, an annuity with a guarantee of principal may be a smart choice.
When You Want Guaranteed Income
At its core, any type of annuity is a vehicle meant to provide a stream of income now or in the future. That income stream is guaranteed for your life, the life of your spouse, or both, even after the account value is depleted through annuitization. Guaranteed income features of annuities differ from company to company, so it is important to research what fits your needs best before selecting the right option. However, for those who are in need of a strategy for creating their own, private pension, an annuity can be a viable tool for achieving this goal.
When You Want a Better Return than CDs or Government Bonds
Originally, annuities were designed to compete with lower-risk, and therefore lower-return savings and investment vehicles, like certificates of deposit and government bonds. To this day, some fixed annuities offer a higher interest rate than these types of accounts, and tax deferral which compounds earnings over time. Indexed and variable annuities give the potential to earn more than certificate and bond options, but you take on a greater investment risk in return. It is necessary to weigh the fixed or potential return against other aspects of an annuity before purchasing, including surrender charges, investment risk, and other costs.
When You Want Tax Deferral
All annuities offer tax deferral of earnings while the money remains in the account. It is only when the annuitization button is pushed that you must account for taxes paid on earnings, or in pre-tax retirement accounts, when the full amount is withdrawn. Although annuities do not provide additional tax benefits when used to fund a qualified retirement account (i.e., a rollover IRA), they do safeguard non-qualified funds from taxes for as long as the money remains in the account. Tax deferral gives your money more of an opportunity to compound earnings over time. However, you do owe taxes once the funds are withdrawn in the future.
The Bottom Line
Purchasing an annuity can be a smart strategy to solve some challenges of generating retirement income for your lifetime, but doing so comes with many factors to consider. If you have little need for liquidity, you are looking for guarantees on principal or future income, or you want to enjoy tax deferral of gains on non-retirement money, an annuity purchase may make sense for your situation. Before making your decision, just be sure to understand the caveats of the specific annuity you choose and how that fits into your overall retirement planning picture.