Annuities represent one of the more reliable passive income revenue streams that you can incorporate into your financial planning strategy. They require that you put up an initial investment of capital — the larger the better if you want to see a robust return on your money.
Annuities aren’t much different than any number of other retirement accounts where you make a series of payments into the account over time. However, with an annuity, you have the choice of making one lump sum contribution instead of spacing them out.
In order to buy an annuity, contact your insurance company, which will accept your investment and hold on to it until you reach a certain age. Then, when that time comes, you can begin to draw down regular distributions of income from the account.
Each payment you receive includes a reimbursement of your principal. Also, it’s comprised of a portion of any interest that has been earned on the account while the insurance company was in possession of your money.
When you decide to get into an annuity, you have three main types from which to choose: fixed, variable, and indexed. They all have a particular anticipated rate of return. It is predicated upon factors like how the annuity is established and the amount of your initial investment.
These financial vehicles are designed with the intent of providing you with an income in your retirement years. You also have options as to when you can begin to start taking your payments and how routinely those payments are disbursed. You can take the full amount at one time. Alternatively, you may take repeating payouts that come monthly, quarterly, even annually should you prefer.
The size of each payment is typically reliant upon the amount you have put into the account, interest rates, and the length of time over which you wish to be getting paid. The type of annuity you select, variable, fixed, or indexed, will also determine how much you receive.
You can set the time you wish to begin the payment cycle. Some folks have them set up to continue for the remainder of their life. Others put a cap on the number of years that they receive their funds.
All of this may sound like relatively basic stuff that can be of real economic benefit in your twilight years. However, the one major drawback of incorporating annuities into your retirement investment planning is that they can be costly.
This makes them a poor investment option for some people. While insurance companies and financial advisers alike usually suggest annuities to senior citizens and other retired individuals, the important thing to do first is your homework.
Only you know what your financial situation looks like. Making an educated decision with your present condition and future goals in mind will do you a lot of good in the long run.
Categories of Annuities
Regardless of whether you decide to go with a fixed or variable annuity, there are two main categories that all of them fall into: deferred or immediate.
Deferred annuities take your capital and invest it for a determined length of time until you decide to begin drawing down your payments. This length of time typically extends into your retirement. Thus, your income revenue begins after you have left the workforce.
Immediate annuities take your capital, invest it. Then, they start paying out almost immediately after, hence, the name “immediate”. Some investors buy into an immediate annuity as they are nearing retirement. At which time, they don’t have the luxury of time to let their money grow.
That’s the biggest difference between the two categories. The former allows you to build wealth before your payouts commence. The latter pays out right after you invest. Let’s say you have a prior deferred annuity. You can easily switch it over to an immediate annuity at the time you wish to begin disbursements of your funds.
The Advantages of Choosing Annuities
Like most retirement products, the biggest advantage that comes with annuities is taxes. While your account is accumulating wealth, you can defer any taxes on it. An annuity differs from another retirement investment vehicles like an IRA or your 401(k).
With an annuity, you aren’t limited as to the amount of money you can contribute to the account each year. Those other investment products come with funding restrictions.
Consequently, an annuity gives you the opportunity to squirrel away as much as you wish. That can be helpful for older individuals who are reaching their retirement years. They want to make up for lost time in case they haven’t been saving diligently enough.
Investing your money into an annuity means it will compound annually. Plus, you won’t have to worry about paying the taxes on those earnings. It’s another reason why choosing an annuity is advantageous over other investment products that are subject to taxes.
When you’re ready, start taking your payments whenever you wish for however long you wish. Those disbursements are guaranteed income for the duration of the term.
The Disadvantages of Selecting Annuities
So far, annuities may sound like a smart choice. However, there are always two sides to the same coin. That is because the advantages come with deferred taxes and no contribution limits.
Yet, the disadvantage comes from the expenses you will likely incur by way of fees and charges. These can start to whittle away at your earnings giving you pause before you might readily invest.
The first expenditures that you will be responsible to for come in the form of commissions to brokers and insurance salesmen. They make their living selling these products. Therefore, they expect to be paid for their service. They get a cut of the money as a commission.
Some firms charge as much as 10%. If you go with a variable annuity, you will be assessed annual fees. They include a yearly insurance charge. It’s typically in the neighborhood of around 1.25% to 1.5%. There are other annual charges as well. Management fees, rider fees, and various other charges that could represent an aggregate total of 3% to 4% a year taken out of your pocket.
Then you could be charged surrender fees. They can be tacked on in the event you withdraw your money too early. Let’s say you decide to take your money out of the annuity in just the first two or three years after you make the purchase.
In that case, you may face losing up to 7% of the value of the annuity if you abandon the account after the first year. That fee is reduced by one whole percentage point for every year the annuity account remains active. This is until enough years have passed to bring the percentage to zero.
Investment Choices with Annuities
Based on the type of annuity you select, your investment options can change when you buy in. Fixed annuities don’t rely on your decisions when choosing the types of investments that earn you money. The insurance company you’ve chosen typically deals with that side of the transaction.
In turn, they promise to pay out a return that is fixed. With a fixed annuity, the money you receive has already been predetermined and you can expect those payments to remain the same every time.
Going with a variable annuity puts you in control of how you invest your capital. You can choose from any number of funds that are offered as part of the annuity and the insurance company.
Your account value rises and falls based on how well the funds perform. The profits you earn are dependent upon the success of your investing decisions and yours alone (though you may wish to consult with an adviser). Remember, the money you gain is tax-deferred.
The profits you earn are dependent upon the success of your investing decisions and yours alone (though you may wish to consult with an adviser). Remember, the money you gain is tax-deferred.
Investing in an annuity will require you to make some decisions on the structuring of your payouts. You have a variety of choices. This is because the disbursement schedule that is right for one individual may not work for another. That’s why there are a number of ways to set your payment timetable.
Many annuities buyers will select a lifetime payment plan. It only guarantees routine payments for the lifespan of the account-holder. Once they pass away, the payments come to an end. The remainder of the money, if there is any, does not payout to a named beneficiary or any of your heirs.
The money just ceases to be paid out. This timetable is available with fixed and variable annuities. Additionally, your payments are calculated based on the amount you invest and your estimated life expectancy.
Perhaps you wish for the money to continue paying out to a beneficiary or beneficiaries after you die. You will want to select a joint and survivor annuity plan. That way, your spouse or any other heirs will receive disbursements from your money for the remainder of that individual’s lifetime.
Another option is called “the period certain annuity”. It guarantees a set income amount for the length of a predetermined amount of time. Payments are received on a routine basis during this term. They can be as little as a few years to as long as 30 or more. If you pass away before the established length of time, the remaining funds will go a beneficiary.
This is a similar scenario to an annuity that comes with a “period certain benefit”. It guarantees payments for life but comes with a “period certain” stipulation in the event of your death. While you’re alive you get disbursements. If you pass away during the period certain phase in the agreement then any named beneficiary would get the money.
However, this is only for the remaining amount of time left on the period certain phase. That may sound confusing. We will clarify that. Let’s say you have a period certain annuity which has a 10 year period. That means you start taking your payouts. Yet, if you die three years into the period certain phase then your beneficiary would collect for seven years or the remaining years of the period certain phase.
Withdrawals From an Annuity
We’ve already talked a little bit about the fees that come with part and parcel when buying into an annuity. Also, we’ve discussed how you can be charged for taking your money out of the account prematurely. Now we take a closer look at the how’s and why’s associated with those stipulations. Simply put, taking money out from an annuity can get somewhat expensive if you don’t follow the rules.
Similar to other ways to increase your nest egg, this type of retirement investment vehicle has some restrictions on when you can start accessing your money. These funds have been set aside for your future. For this reason, you are discouraged from taking the funds out until the age of 59 years and 6 months.
That doesn’t mean you are forbidden from taking the money. Nevertheless, you will be penalized for doing so in the form of a 10% penalty tax in addition to any applicable income taxes on the earnings that accrued on the account. Yet, that is only your earnings are taxed. The initial capital you invested is not.
If you opt to take money out at some point during the first five to seven years or purchasing the annuity and you will likely be on the hook for those surrender charges. Remember, the longer you leave the money alone the percentage you would owe will drop down to nothing. Then, you won’t face any fees for withdrawals.
Variable, Fixed, or Indexed?
Which one is the best option? We’ve examined the various categories of annuities. We’ve learned what makes them a good investment option, the payout arrangements that they offer. Additionally, the fees that come with an annuity.
Now we’ll take a look at the three major types of annuities that you can choose from. Each one has its own distinct set of advantages and disadvantages. They might make one a better choice over another for your retirement plans.
If you’re looking for a versatile and tax-deferred investment option, then a variable annuity might be the best option. You get to make your own choices as to how your money will be invested.
Also, your earnings and eventual income are based on the success of those choices. That means your payouts are not guaranteed, if you want steady disbursements then you need to look into a fixed annuity.
What’s Great about Variable Annuities
Buying into a variable annuity gives you the opportunity to accrue some real wealth through the long-term growth of your initial principle. You’re the one in control of your investing strategies. That is because you have a list of portfolios to choose from which contain “sub-accounts”.
These are similar to mutual funds that are composed of stocks or bonds. The money you earn in returns is tax-deferred. Thus, you won’t pay any taxes on them until you receive the money in a payout. This option has serious potential for earnings growth. Accordingly, variable annuities typically outpace inflation more often than a fixed alternative.
What’s Not So Great about Variable Annuities
Fees and charges are the biggest drawbacks to choosing a variable annuity. Furthermore, you risk losing some of your principal. That is because the investments you choose to fund under the annuity could under-perform or bottom out altogether.
There is a greater risk to your money with a variable option. This could be a serious disadvantage to investors who are keen on saving as much as they can for retirement.
For a little more stability in your savings, a fixed annuity is the way to go. They have the security of a certificate of deposit. In such, you have little to no risk of losing your initial investment. Plus, they pay out a guaranteed income based on the interest that is earned.
The amount of interest you can gain is often better than what you may receive from a CD issued by one of the banks like Chase or IBC Bank. You can turn that fixed annuity into a deferred or immediate annuity. The former will accrue wealth. The latter will distribute fixed payments that won’t change. The amount is based on your age and the size of the annuity.
What’s Great about Fixed Annuities
The guaranteed revenue stream is the best part about fixed annuities. Your payouts come from guaranteed fixed interest rates. In turn, it makes them immune to what’s happening with the economy.
Regardless of how the stock market is performing or rate hikes imposed by the Fed, your disbursements continue, unchanged. You also don’t have to deal with any deposit minimums with a fixed annuity. Therefore, you can invest as little as $1,000 in some cases. Best of all, perhaps, the money you earn is also tax-deferred.
What’s Not So Great about Fixed Annuities
Remember how we just said the rates are fixed on a fixed annuity? That can sometimes be only partially true. That is due to the fact that a fixed annuity could see a reduction in rates after a certain period of time.
After that happens, you don’t have too many options should you dislike the new rate. You can’t really take the money out of the account. If you do, you could be saddled with all those penalties for early withdrawal that we discussed up above.
Another not so great thing about a fixed annuity is that your payments won’t increase over the course of your payment schedule. For this reason, they won’t keep up with the rates of inflation.
Consequently, the value of your payments will actually decrease over time as inflation rises. Your money is worth less than it was in the years prior, even though you’re getting the same payment on a continuing basis.
Indexed or equity-indexed annuities take some of the facets of a fixed annuity. Plus, they take some of the facets from a variable annuity and combine them into one product. That means you can enjoy a guaranteed return on your money. Yet, that return could be higher than first anticipated since it’s directly affected by one of the indexes like the Standard & Poor’s 500.
What’s Great about Indexed Annuities
You get to enjoy facets of both fixed and variable annuities. Accordingly, you can enjoy those higher returns when stocks are performing well. You’ll never have to worry about not receiving a payout since these products come with a guaranteed minimum disbursement. Thus, if stocks fall dramatically, you’re still assured of receiving an income.
What’s Not So Great about Indexed Annuities
There are a few drawbacks to these types of annuities. Mainly, it can be tough to fully grasp how they work due to their complexity of combining characteristics of fixed and variable annuities. Some investors just can’t wrap their head around all the nuanced machinations of this form of investment.
Another disadvantage is that the return you could get from your investment may not always reflect the performance levels of the index that your particular annuity relies on. Your gains could be determined through a number of calculation scenarios.
That could limit how much you are actually receiving. Some of these annuities also come with annual earnings caps. Don’t forget all the fees you may be expected to pay out. That is because surrender charges with these types of annuities can be much higher.
Our Final Thoughts
This is a lot to think about. Nonetheless, you have enough information to set you in the right direction to do more research. There is one other thing you should also keep in mind before you take the plunge into annuities. Your investment is supposed to be there when you retire. It could be 10, 15 years down the line.
That’s why you want to be sure that the insurance company you’ve chosen to invest in will still be around when it comes time to start collecting your payments. Solvency is important. Accordingly, if your insurance company suddenly goes out of business, you could lose everything.
Therefore, when you do that research, be sure to check the credit ratings of the various insurers with whom you are contemplating an investment.