An annuity can provide a steady stream of income for retirement. This type of insurance contract allows you to pay a premium upfront, then receive payments from the annuity company at a later date. Annuities offer some financial advantages, but they’re not right for everyone. Before adding one to your financial plan, it’s helpful to understand who should not buy an annuity and why. For help deciding whether or not to purchase an annuity, consider working with a financial advisor.
What Is an Annuity and How Does It Work?
An annuity is a financial product that can be used to create supplemental income. When you buy an annuity, you’re buying an insurance contract. You pay a premium, typically in a lump sum although some annuities may allow you to pay premiums in installments. The annuity company then makes payments back to you beginning on a scheduled date.
Annuities can be immediate or deferred. An immediate annuity typically starts paying out money to the owner within a year of the contract’s purchase. Deferred annuities usually take longer for payouts to begin. For example, you might buy a deferred annuity at age 55 and receive the first payment at age 65.
The money in an annuity can grow in value. Annuities can use different strategies to promote this growth. For example, an indexed annuity is designed to produce returns that mimic the performance of an underlying stock market index or benchmark. Variable annuities pay returns based on the performance of an underlying group of investments, such as stocks or mutual funds.
There are certain fees that apply when purchasing annuities, including administrative costs and surrender charges. There are also tax considerations to keep in mind. Payments from a qualified annuity are taxable as income, and the tax applies to the entire distribution. That’s because these annuities are funded with pre-tax dollars. Required minimum distribution rules also apply to start at age 72.
If you have a non-qualified annuity, you’d only pay tax on the earnings from the distribution. Non-qualified annuities are funded with after-tax dollars. Money in non-qualified annuities grows tax-free, and there are no required minimum distributions.
Who Should Not Buy an Annuity?
Purchasing an annuity might sound appealing if you’d like to create an additional stream of income for retirement. However, there are some scenarios where it may not make sense to put money into an annuity. For instance, you may want to pass on buying an annuity if you:
- Have enough income for retirement: An annuity might be unnecessary if you’re confident that you’ve saved enough for retirement and that Social Security benefits will fill any income gaps. In that case, you might be better off using the money you planned to invest in an annuity to purchase long-term care insurance or pay off any lingering debts before you retire.
- Don’t have sufficient savings to cover premiums: Buying an annuity could mean laying out $50,000 or more to cover the premium. If purchasing an annuity would drain your liquid savings and put you at risk of having to borrow to pay for unexpected expenses, it may not be worth it.
- Haven’t funded other savings goals yet: Retirement may be your biggest savings goal, but you may have other targets you’re working on in the near term. If buying an annuity would require you to delay those goals by several more years, you’d have to consider whether it makes sense to accept that trade-off.
- Are likely to have a shorter life expectancy: Annuities can provide lifetime income, and the longer you expect to live, the more you’ll benefit. If you have a chronic or serious illness that you anticipate will shorten your lifespan, on the other hand, you might get a better use for your money by purchasing life insurance to leave to your loved ones instead.
- Haven’t done your research: Annuities can be complex financial products, and they’re typically not something you want to buy if you don’t understand how they work. Talking to a financial advisor can give you a better idea of whether an annuity makes sense.
Who Should Buy an Annuity?
An annuity could be suitable for someone who is approaching retirement and needs or wants to create an additional stream of income. Annuities can provide lifetime income, and depending on the type of annuity, you may also get some protection against market volatility. With fixed annuities, for example, you can earn a consistent rate of return even during periods of market decline.
Annuities could also be a good fit if you have money to spare for premiums and you understand the fees you’ll pay. For example, the annuity company may offer to add one or more riders to your contract. Annuity riders can offer enhanced benefits – but adding them often means paying more in fees.
If you’re able to max out your 401(k) at work and you’re maxing out an IRA each year it might be wise to consider buying an annuity. However, consider the returns you’re likely to get. It’s possible that you could get better returns by investing money in stocks, mutual funds and other securities through a taxable brokerage account. You’d have more liquidity, and you’d avoid some of the high fees typical of annuities.
How to Choose an Annuity
If you’re considering an annuity, it’s important to research different types of annuities to decide what might work best for your financial plan. Annuities can have different risk-reward profiles, and it’s helpful to understand how they align with your own risk tolerance and goals. When comparing annuities, look carefully at the fees. Also, it’s good to take time to research the annuity company itself to make sure it’s reputable.
An annuity product is only as good as the annuity company itself. A company with strong ratings is more likely to be financially healthy. That means they’ll be able to make your annuity payments when the time comes.
An annuity company with lower credit ratings, on the other hand, might be more likely to default or end up in bankruptcy. In that case, you may not receive anything at all when it’s time for your annuity payments to begin.
The Bottom Line
If you’re wondering whether an annuity is right for you, it helps to look at your entire financial situation. Consider how much you have saved for retirement, what you have in liquid savings, how much debt you’re carrying and your goals. That can make it easier to determine whether an annuity is suited for meeting your income needs.
Retirement Planning Tips
- Consider talking to a financial advisor about whether an annuity is something you might need. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have free introductory calls 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.
- If you purchase an annuity and then decide later that you no longer need it, there are some different ways to get out of it. For example, you might be able to cancel the purchase if you’re still within the “free look” period. You may also choose to surrender the annuity. When comparing different ways to get out of an annuity, pay attention to any fees you might pay or tax consequences you may trigger.
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