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What You Should Know About Annuities



Money Girl listener Marsha U. writes: “I work at a university, so my retirement is through TIAA. When I recently spoke to their rep, she suggested an annuity with half a variable product. I’m 65 years old and will retire at 70, so I have some time to decide. Can you explain what I should know about annuities?”

Thanks for your question, Marsha! Annuities can be a wise way to save for retirement if you fully understand them. So, I’m delighted you asked. This episode will review how annuities work, the different types, and how they relate to saving enough for a comfortable retirement.

What Is an Annuity?

Annuities have been around for a long time and are commonly used by retirees who want to make sure they’ll have a regular income for the rest of their lives. Since getting a big, fat pension from your employer is a luxury that fewer American workers can look forward to, an annuity may complement other retirement plans you have.

In its simplest form, an annuity is a contract between you and an insurance company that provides a combination of insurance and investment features.

Annuities are sold by various institutions and professionals, such as insurers, banks, brokerages, and financial advisors. The investment firm that manages Marsha’s retirement, TIAA, is one of the largest pension funds in the U.S. They manage retirement accounts for workers in many fields, including universities, government, nonprofits, and medical services.

To purchase an annuity, you make one or multiple payments in exchange for a set amount of income for a period. Depending on what type of annuity you select, it may give you the following benefits:

  • Guaranteed income for your entire life
  • Tax-deferred growth
  • Guaranteed investment return
  • Protection from investment losses
  • Flexible withdrawals
  • Protection for your beneficiaries

One advantage of an annuity is that you can contribute as much as you want for retirement, provided you have a non-qualified annuity (I’ll get more into that later). Unlike other tax-deferred vehicles, such as a workplace 401(k) or an IRA, annuities have no annual contribution limits. That can be particularly helpful if you’re close to retirement age and need to catch up.

How Do Annuities Work?

As I mentioned, you can purchase an annuity by making a lump sum payment or multiple payments, called premiums, over time. In return, the annuity provider invests your money and typically gives you a series of payments, known as annuitization.

Here are three main types of annuities:

1. A fixed annuity pays out a fixed rate of return on your money for life or a specific period. It’s a guaranteed, predictable income stream, no matter what’s going on in the financial markets.

2. A variable annuity pays out a variable rate of return on your money. The income stream usually has a minimum guaranteed amount, but can increase depending on the performance of the underlying investments that you select, such as stocks or mutual funds.

3. An indexed annuity pays a return on your money that’s tied to an economic index, such as the S&P 500. It’s considered a hybrid of the fixed and variable types because you receive a minimum guaranteed payment for life or a period. However, you can also enjoy a higher return when there are gains in the broader market.

Marsha said that TIAA recommended a half variable annuity. I’m not sure exactly what the rep meant, but it may be an indexed product. With variable and indexed annuities, you have more risk, but you also have the opportunity for higher returns depending on the performance of the financial markets.

What Is an Immediate Annuity?

In addition to annuities having different investment options, there are two main ways an annuity can pay you, depending on whether it is immediate or deferred.

An immediate annuity provides income right away or at least a year after you buy it. You make a lump sum payment, called a single premium, and start receiving a monthly income stream.

Let’s say that you receive a life insurance payment of $1 million after taxes, and you want to create a monthly income by putting it in an annuity. You can use various immediate annuity calculators to see the payout based on your age and gender.

If you’re a 40-year-old female, a $1 million annuity will give you a little more than $3,000 a month for the rest of your life. The payout changes depending on when you buy an annuity. If you purchased the same $1 million annuity at age 60, it would pay out a bit more than $4,000 per month.

What Is a Deferred Annuity?

The other broad category of annuities is a deferred annuity, where you receive income at a future date. You make one or multiple contributions during the annuity’s “savings phase” and then receive income either as periodic payments or as a lump sum during the “distribution phase.” The payout doesn’t begin for at least a year after your last premium payment but may be deferred by up to 40 years.

A deferred annuity is similar to retirement investing where you set aside money over time to access in the future. In fact, you can own a deferred annuity inside of a retirement account, such as a traditional IRA, 401(k), or 403(b). That’s probably the situation with Marsha’s TIAA account.

What Is a Qualified Annuity?

If you own an annuity inside a retirement account, it’s called a qualified annuity and is subject to traditional retirement account rules. For instance, your contributions are tax-deductible, up to the annual IRS limit. And you defer paying tax on the annuity’s earnings each year until you make withdrawals after age 59½.

You must begin taking distributions with a qualified annuity once you reach age 72, following traditional retirement account rules.

What Is a Non-Qualified Annuity?

When you own an annuity outside of a retirement account, it’s called a non-qualified annuity, and you only have the option to contribute after-tax dollars. There are no annual contribution limits, so you can put in as much money as you like.

Even though you pay tax upfront on contributions to a non-qualified annuity, you defer paying tax on investment earnings until you take withdrawals after age 59½. And unlike a qualified annuity, you don’t have to start taking distributions at any specific age.

So you don’t get as many tax advantages with a non-qualified annuity; however, it doesn’t come with as many restrictions.

What Is an Annuity Rider?

Like adding a rider to a home insurance policy to protect valuable jewelry, you can add a rider to an annuity and receive optional benefits above the standard contract. A few common annuity riders include:

  • Income rider provides guaranteed income for a certain period that you can turn on in the future. That’s a popular option for retirees who want to make sure they don’t run out of money during their lifetime.
  • Death benefit rider ensures that if you die, your beneficiary receives the balance of your annuity, not the insurance company. For example, if you purchase an annuity for $100,000 but die after receiving only $20,000 in distributions, your beneficiary will receive the $80,000 balance.
  • Nursing home rider helps pay for expensive long-term care, either at home or in a nursing facility. For instance, it may double your monthly income or allow you to withdraw more of your annuity balance to cover your added costs.
  • Terminal illness rider allows you to access some or all of your annuity balance without having to pay early withdrawal fees or surrender penalties if you’re diagnosed with a terminal illness that reduces your life expectancy.

Adding a rider to an annuity gives you extra financial protection, but it comes with a cost because it increases the amount of income you’ll receive.

Can You Tap an Annuity Early?

A deferred annuity acts a bit like a retirement account, even if you don’t own it inside of a retirement account. You enjoy tax-deferred growth until you take withdrawals after age 59½. But you’ll need to wait until 59½ if you want to enjoy the full benefit of your annuity.

Taking an early withdrawal from an annuity is typically subject to income tax, plus a 10% penalty. Some annuity providers also charge an additional penalty, called a surrender charge, for taking an early withdrawal.

What Are the Downsides of Annuities?

The main advantage of an annuity is getting payment amounts that an insurance company partially or fully guarantees. That’s something most regular investments, such as mutual funds, can’t provide.

However, regular investments, such as stocks and stock funds, offer a long-term upside that annuities generally can’t match. In other words, buying an annuity means you’re protected from the market going down, but you give up the opportunity to earn higher returns. Plus, annuities generally come with higher fees than regular investments.

Remember that the value of an annuity is reducing your investment risk. It gives you a guaranteed income but not necessarily the highest potential income for your money. In exchange for an annuity’s fixed or guaranteed payout, it limits your possibility of getting higher income when the market goes up.

By transferring the risk of investing to an insurance company, it may give you peace of mind that your income in retirement would never dip below a threshold. But the downside is that if you had put money in regular investments instead of an annuity, your retirement income could be higher. Only you can decide whether having a potentially lower amount of guaranteed income is the best choice for you.

Get Financial Advice About Annuities

There’s a lot to consider when it comes to annuities, such as taxes and estate planning. In addition to the riders we covered, there are many more options you can choose at an additional cost, such as a cost-of-living adjustment to increase your income each year.

Marsha, you’re doing the right thing by speaking with a professional about your options. I’d make sure you fully understand the pros and cons of different annuities and riders until you’re confident that it meets your and your family’s needs.

Since annuities are complex financial products, always consult with a qualified financial advisor about whether buying one is a good fit for your long-term financial and retirement planning strategy.

This article originally appeared on Quick and Dirty Tips.

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