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How Do Annuities Work?

When it comes to retirement, Social Security and your 401(k) plan don’t always cover you throughout your retirement. If you’re planning for retirement, you might want to also consider opening an annuity. Annuities are long-term investments that help protect you in retirement should you outlive your income. You can open an annuity with an insurance company or nonprofit agency, which distributes payments back to you.

Fixed Annuities vs. Variable Annuities

When you open an annuity, you can choose between two major types: fixed and variable. Fixed annuities pay out equal amounts while variable annuities’ amounts change with investment performance.

When you sign up for a fixed annuity, you agree to a certain interest rate that determines your future payouts. For example, if you invest $1,000,000 in a fixed annuity with a 3% rate, you will receive annual payments of $30,000. The rate you agree upon at opening will remain the same for the duration of your annuity. While this does make for more certainty, the rate of inflation may outpace your rate of return, effectively lowering your purchasing power.

Variable annuities make payments determined by the performance of your investments. When you initially invest, you choose from a selection of stock or bond portfolios. These selections and how well they perform directly determine your future payouts. Choosing a variable annuity takes on a certain amount of risk that depends on the market. Throughout the life of your annuity, the market could underperform or decline, thus decreasing your payouts. Of course, the opposite could also be true where you end up with a higher payout than with a fixed annuity. It is important to note that variable annuities charge sales commissions and high annual maintenance fees, which could cut into your return.

There is also the equity-indexed annuity, a specific type of variable annuity. An equity-indexed annuity provides some of the stability of a fixed annuity while allowing for a performance-based payout. Instead of choosing a portfolio, your annuity is tied to a benchmark index, usually the S&P 500. This ties your returns to the stock market’s performance as a whole. An equity-indexed annuity also guarantees a minimum return even if prices fall, reducing the risk of a typical variably annuity.

Immediate Annuities vs. Deferred Annuities

How Do Annuities Work?

You can also choose when you want to start receiving your annuity payments. If you want to start receiving them immediately, you can open an immediate annuity. Immediate annuities start paying out returns soon as you’ve funded your account. This option makes sense if you’re already retired and want to guarantee regular income payments for the rest of your life.

On the other hand, you can open a deferred annuity. These types of annuities don’t start paying out returns until you want to start collecting, typically once you retire. You’ll make your deferred annuity investment now, wait while your investments grow then start withdrawing in 10, 20 or 30 years’ time. Deferred annuities offer high-income investors the ability to defer tax payments on their nest egg. To the opposite, a young person, worried about their current state of retirement savings, can also use a deferred annuity to ensure they receive payments throughout their retirement.

Is an Annuity Right for You?

Just like any investment, you’ll want to weigh the pros and cons of annuities before opening one. For starters, annuities allow your money to grow tax-deferred. This means you pay taxes on the annuity’s gains when you withdraw the funds. Note that your capital gains from a variable annuity are taxed at ordinary income rates, not lower capital gains rates. This could result in higher taxes for high-income investors.

As tax-deferred accounts, annuities can be a good option for investors who have already maxed-out their 401(k) plans and IRAs. Not only do they offer another outlet for retirement saving, but annuities don’t have an annual contribution limit. You can even find an annuity program offered by a charity. This allows you to make your annuity payment(s) as a tax-deductible donation to charity.

These tax benefits don’t quite come free, though. You’ll likely have to pay commissions to the financial professional who sells you your annuity, as well as annual fees for investment management. You tend to see higher fees with variable annuities than with fixed annuities.

Annuities are designed to hold onto your funds until your withdrawal period begins. This means if you try to withdraw from your annuity early, you’ll face surrender fees. So even if an emergency pops up and you need your deposit back, you’ll pay a hefty percentage fee to do so.

Finally, the FDIC does not insure annuities. So if your insurance company goes under, your money is lost. Also, annuities don’t automatically provide a way for your heirs to receive any remainders if you die before receiving all of your principal back. You may work with your insurance company to allow for a second beneficiary, however.

The Takeaway

How Do Annuities Work?

Annuities offer a great option for additional retirement savings. You have multiple options available to you so you can open an account depending on your retirement and financial status. Don’t forget to keep track of your annuity’s tax benefits, fees and risks. That way, you can avoid high fees and only benefit from your account.

Tips for Saving for Retirement

  • Finding a financial advisor now can really help you save the most for your retirement. The right advisor can help you understand annuities, maximize your 401(k) and IRA contributions and more. That way, you don’t have to navigate your savings and future by yourself. If you aren’t sure where to start looking for a financial advisor, SmartAsset can help. After you answer a short questionnaire, our financial advisor matching tool will pair you with up to three advisors in your area who fit your specific financial needs. You can then read the advisors’ profiles and interview them to decide who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
  • Don’t have a 401(k) or IRA? These accounts are crucial to retirement saving. Not only that, but you’ll want to maximize your contributions to your accounts as best as you can. Just be aware of the legal contribution limits for retirement accounts like these.

Photo credit: ©iStock.com/AndreyPopov, ©iStock.com/AJ_Watt, ©iStock.com/JohnnyGreig

Danielle Klimashousky Danielle Klimashousky is a freelance writer who covers a variety of personal finance topics for SmartAsset. She is an expert on topics including credit cards and home buying. Danielle has a BA in English from Wesleyan University.
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