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How to Use Annuities for Income in Retirement

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Your retirement plan can keep you up at night, especially if you are nervous about outliving your nest egg. But many Americans get peace of mind by adding annuities to their retirement plans. This financial product is an insurance contract that can pay you retirement income for a certain amount of years or a lifetime. Here’s what you need to know.

A financial advisor can help you find additional sources of income to stretch out your retirement nest egg.

Types of Annuities

While annuities can pay you retirement income, the terms differ by contract. Generally, there are two types of annuities:

  • Immediate annuities are basic contracts that convert lump-sum contributions into streams of income. These can last for a specific number of years or a lifetime. 
  • Deferred annuities, by contrast, are structured to let policyholders build cash value through multiple contributions over a longer period of time.

Annuities are also categorized by the type of rates that the contract offers:

  • Fixed annuities guarantee a specific payout based on periodic payments.
  • Variable annuities will allow you to benefit from higher and lower rates, depending on how fund investments perform.

How Do Annuities Pay Income?

Man analyzes his financial holdings

You can buy an annuity through periodic contributions or by making one lump-sum deposit. In exchange for this money, the insurance company will offer you a stream of income that depends on the terms of your contract. 

A fixed annuity, for example, can pay you a specific rate that is based on how much money you invest. Typically, the more time you have to put money in, the more you will be able to earn through compound interest

A variable annuity, on the other hand, relies on performance. So this contract can actually pay you more than a fixed annuity when an investment offers high returns. You should note, however, that you can also lose money with market downturns.

One key note: Annuities allow your contributions to be tax-deferred. This means that you will need to pay taxes on that income when you make a withdrawal or get an annuity payment.

Pros and Cons of Using Annuities in Retirement

Before you put your money into an annuity, let’s examine four common drawbacks:

  • Annuities can be expensive. Depending on your contract, you’ll have to pay a variety of fees. And these can range from commissions to expense ratios for investments and surrender charges. Make sure you compare these fees against other retirement income options to see which is a better fit for your retirement plan.
  • Insurance companies are not FDIC-insured. Unlike banks or credit unions, insurance companies are not covered by FDIC insurance. So your annuity payments will rely on the company’s financial strength and its ability to pay those benefits.
  • Your money is locked by the terms of the contract. Annuities typically limit withdrawals to a percentage of the contract’s value. So it could be difficult for you to gain access to your funds quickly without having to pay a surrender charge or losing on compound interest. You may consider building an emergency fund to pay for unexpected expenses. 
  • Your rate may not keep pace with inflation. Whether your contract is fixed, or you have a variable annuity that can capitalize on market upswings, your income payments could still fall short when your cost of living goes up. 

Now, let’s take a look at reasons why you may want to buy an annuity. Aside from the most common one – annuities can offer you steady, guaranteed income – you may want to keep this in mind:

  • You can pass money to a beneficiary. Many contracts include death benefits, which get paid to the person that you appoint as a beneficiary. This feature could require you to pay an additional cost, so do the math before buying the contract. 

Additionally, we have already covered these two benefits: Your contributions can grow tax-deferred and fixed annuities guarantee rates of return.

Bottom Line

Couple reviews their Roth IRA's performance

Buying an annuity can help ensure that you won’t outlive your retirement savings. But, before you invest, review the terms of your contract to make sure that the rates, fees and special features are a good fit for your needs.

Retirement Savings for Beginners

  • A financial advisor can help you create a financial plan for your retirement goals. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • SmartAsset’s free retirement calculator can help you figure out how much you will have for retirement based on your expected retirement age, annual income and retirement expenses.

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