Those nearing retirement age may be looking to supplement their income. If they’ve already maxed out their other retirement savings accounts, like their 401(k) or IRA, then an annuity might help. Annuities come in many variations, including fixed, variable, indexed, immediate and deferred. We break down the different types of annuities so you can decide if one is right for your financial situation.
Annuities: The Basics
An annuity is a contract between an investor and an insurance company. The investor buys an annuity with a lump sum of money and the insurance company promises regular disbursements for a specific period of time in return. These payments begin when the investor, also called the annuitant, chooses to annuitize their investment. The annuitant chooses the amount paid and how frequently they receive the payments. They also decide if they want a lump sum payout or regular disbursements. However, it all depends on the type of annuity.
Annuities may also earn interest, but the amount depends on the type of annuity and market conditions. These financial instruments also enjoy tax-free growth, which can be another attractive aspect for investors. Keep in mind though that you will pay income tax on all or part of the annuity disbursements. There’s also typically a 10% tax penalty on the interest earned if you withdraw money before age 59 1/2.
Many see these contracts as a great way to supplement retirement income, some even view annuities as a guarantee against running out of money during retirement. That, of course, depends on the type of annuity you invest in and the duration of your annuitization payments.
As the name suggests, a fixed annuity provides an investor with a guaranteed interest rate for a set number of years. Fixed annuities are one of the most common forms of annuities and are fairly straightforward.
Basically, the purchaser invests a sum of money with an insurance company. The company then agrees to pay a set amount of interest for a predetermined amount of time, plus principal protection, as a return on the investment.
If you invest in a fixed annuity, how you receive your earnings varies between a set number of years or for life. The latter makes this type of annuity popular with those in retirement. You can also opt to receive your funds via a lump sum payout. Keep in mind that this type of annuity is not linked to market performance.
With a variable annuity, a purchaser pays into an annuity, but does not receive a guaranteed interest rate for a set period of time. Instead, an investor would receive returns based on the performance of the investments within the annuity. These investments can range from stocks and bonds to money market instruments and adhere to different risk tolerance levels. This allows for potentially greater returns, but also less-than-stellar ones. While the overall risk is higher with this type of annuity, it still provides principal protection.
An indexed annuity is an annuity contract that guarantees a minimum rate of return, with the potential for higher returns based on market performance. This type of annuity is commonly based on indexes such as the S&P 500, but can also follow other indexes as well, depending on investor preference. It’s often known as a fixed indexed annuity since it combines features of both a fixed annuity and a variable annuity.
Indexed annuities can earn larger returns for investors. However, overall income can be limited by rate caps, which limit the returns an annuity holder can claim over a certain timeframe. This type of annuity also has a minimum rate of return, often about 2%. Even though these indexed annuities contracts can be more volatile, the principal is still guaranteed – unless you make a withdrawal, of course.
Immediate annuities may be ideal for those who have a large amount of money on hand. An investor buys an immediate annuity with a large lump sum payment and then receives regular payments over a set period of time or as long as they live. Payments begin immediately (hence the name) and the investor can earn a fixed or variable interest rate.
So why would you tie up a large amount of cash in an annuity? There are a few reasons. An annuity grows tax-deferred. It also provides a steady stream of income for a set period of time and takes away the worry and anxiety around managing a large sum of money.
With deferred annuities, an investor receive payments in the future only after the initial amount used to buy the annuity has accrued interest. Basically, it’s the opposite of an immediate annuity.
Deferred annuities have an investment phase and an income phase. The first phase begins when an investor buys the annuity and ends when the last contribution is made. You can contribute one lump sum or pay into the annuity over time. You start the income phase once you’re done making your contributions. This is when you receive payment, either in one lump sum or through disbursements over time.
Fixed, variable and indexed annuities can also be deferred annuities.
The Bottom Line
There are several important distinctions between fixed, variable, indexed, immediate and deferred annuities. There are also qualified and unqualified annuities, which are distinguished by their tax treatment It’s important to do your homework before deciding which type of annuity to purchase. Overall, you may only want to invest in an annuity if you have maxed out your other retirement savings vehicles and won’t need access to the cash in the near future, as annuities are relatively illiquid. And remember, the success of your investment may depend on the financial health of the insurance company backing it.
Tips for Growing Your Money
- Consider speaking with a financial advisor before buying an annuity. A financial advisor may be able to help you find the right vehicle for your money to grow in. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- An annuity may help you diversify your portfolio. Consider your risk tolerance and all of the various types of investments that can help your money grow. From stocks and bonds to mutual funds and exchange-traded funds (ETFs) there are many investments to consider outside of annuities.
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