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What Is a Retirement Annuity?

what is a retirement annuity

A retirement annuity is a basic annuity where you pay on a contract for a set period of time and in return receive income, often for life. Retirement annuities provide predictable income, giving people increased financial security and peace of mind. Here is how retirement annuities work and how to decide whether they might be right for you.

For help deciding whether a retirement annuity is right for you, consider working with a financial advisor.

What Is a Retirement Annuity?

A retirement annuity is a financial product that provides a guaranteed income stream during retirement. You can purchase a retirement annuity with either a lump-sum payment or by making premium payments over time. You can buy a retirement annuity from an insurance company. You can use a retirement annuity in combination with other retirement savings vehicles, such as 401(k)s or IRAs, to help ensure a stable and secure financial future.

When you retire, these annuities provide you income for a set period, or in some cases, for life. Retirement annuities can be either fixed or variable. Retirement annuities can be purchased from insurance companies and are often used in combination with other retirement savings vehicles, such as 401(k)s or IRAs, to help ensure a stable and secure financial future.

Types of Retirement Annuities

There are many types of retirement annuities. The best choice for you will depend on your finances and retirement goals. Examples of common retirement annuities include:

  • Defined benefit annuities: These are also known as pension annuities and are sometimes offered by employers. Defined benefit annuities provide a guaranteed income stream for life. The benefit amount depends on a formula that considers your length of service and salary history.
  • Immediate annuities: You can buy an immediate annuity with a lump sum payment. You then begin receiving payments immediately. The payments continue for the rest of your life or for a set period.
  • Deferred annuities: You can buy a deferred annuity with a lump sum payment, but payments do not begin until a specified date in the future. This type of annuity provides you with the ability to accumulate funds tax-deferred while also ensuring a guaranteed income stream in retirement.
  • Fixed annuities: Fixed annuities provide a guaranteed rate of return on your investment, regardless of market fluctuations. The income stream provided is also guaranteed and will remain the same throughout the life of the annuity.
  • Variable annuities: Variable annuities allow you to invest in various investments. These include things like mutual funds, stocks and bonds. The return on investment and the income stream provided is not guaranteed and will vary depending on the performance of the underlying investments.

Benefits of Retirement Annuities

what is a retirement annuity

Retirement annuities have several advantages for retirees. As discussed earlier, their biggest advantage is that they provide a guaranteed income stream that can last until the end of the retiree’s life. This can make retirement planning easier. Another potential benefit is tax advantages, as retirement annuities may provide tax-free growth.

Another benefit of retirement annuities is that typically, they are professionally managed. This eases the burden on you as the retiree. Plus, annuity managers usually have the expertise and resources to manage the underlying investments and ensure a steady income stream for retirees.

Risks and Limitations of Retirement Annuities

When used properly, annuities can give you an increased sense of financial security. However, they can still have some risks and limitations you should keep in mind. The biggest risk is their limited liquidity. For instance, if you pay premiums on a deferred annuity, that money generally isn’t accessible until you start receiving benefit payments. There is sometimes a surrender period where you can withdraw some of the funds, but this period is typically limited, and early withdrawals may be subject to penalties and fees.

Another potential issue with retirement annuities is their fees. For instance, there might be management fees, administrative fees and potentially surrender fees. There can also be investment risk. Again, while annuities are often thought of as a kind of safety net, the reality is that some are safer than others. Although some annuities offer a fixed rate of return, others are linked to underlying investments, such as stocks, bonds or mutual funds. In other words, there might be investment risk involved, and the return on investment may fluctuate based on market conditions.

Taxes on Retirement Annuities

Retirees should be aware of the tax implications of retirement annuities. The first point is that while annuity balances grow tax-free, distributions are taxed as ordinary income. This might exceed the capital gains rate. However, you might be able to purchase an annuity with after-tax dollars, such as through a Roth IRA. In this case, payments might be at least partially tax-free. This includes the portion of the payment that represents a return of your original investment. Any portion of the payment that represents earnings may be taxed as ordinary income.

Complexity of Annuities

Retirees should be aware that the calculation of retirement annuity fees can be complex, and different annuities may have different fee structures. Some annuities have a flat fee that is subtracted from your account balance each year, while others have fees that are based on a percentage of your account value. Some annuities may also have additional fees for optional riders, such as guaranteed income or long-term care benefits. However, the specific fees you will incur might be different from one annuity to the next.

For example, there may be administrative fees, investment management fees and surrender charges. There might also be a fee called mortality and expense (M&E) fees, which covers the insurance company’s costs for providing death benefits. M&E fees typically range from 1% to 1.5% of the account value per year. It’s important to carefully review the fees associated with any annuity you’re considering and to understand how they will affect your investment returns over time. A financial advisor can help you compare different annuity options and evaluate the costs and benefits of each.

How to Buy a Retirement Annuity

what is a retirement annuity

Buying a retirement annuity can be a complex process, and you should carefully evaluate your options and retirement goals before deciding. You should also determine how much retirement income you will need, as that will be a major factor in the annuity you will want to purchase. Once you answer that question, evaluate the retirement annuities offered by online brokers and insurance providers. Carefully evaluate each option and choose the one that best meets your financial needs and retirement goals.

You should also work with a financial advisor who can provide guidance and advice on the various retirement annuity products available. They can help you evaluate your options and select the product that best meets your individual needs.

Also, be sure you understand the fine print. Retirement annuity products can have complex terms and conditions, and it is important to carefully review the fine print before making a purchase decision. This can include understanding the surrender charges, income payment terms and any other limitations or restrictions associated with the annuity product.

Bottom Line

Retirement annuities provide a guaranteed income stream in retirement that can last for life or for a set period. Some are purchased upfront with a lump-sum payment, and some are purchased over time with premiums. In addition to their guaranteed payments, retirement annuities can have other benefits, like tax advantages. However, they also have risks and limitations, such as lack of liquidity and high fees. Always review your options with a trusted financial advisor before you decide.

Tips for Retirement

  • A financial advisor can guide you through major financial decisions, like determining your investing strategy. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Deciding how to invest can be a challenge, especially when you don’t know how much your money will grow over time. SmartAsset’s investment calculator can help you estimate how much your money will grow to help you decide which type of investment is right for you.

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