At some point in time, anyone who accrues enough wealth has to figure out what to do with it if they want to make sure it keeps growing along with them. While stuffing your mattress may be one way to handle that, even sticking your money in a bank is no longer a viable option.
Interest rates saw only modest, short-term spikes in the last 20 years and show no signs of improving anytime soon.
Investing is always an option, but markets' insecurity may push some people to seek more reliable alternatives, especially when planning for the end of their careers. Granted, there are numerous ways to accomplish this, but one of the safest and generally more reliable strategies is to take out an annuity.
However, like most commodities in the financial market, annuities are incredibly complex, with plenty of different structures to trip up potential clients. That is why we took the time to break down annuities, examining them from every different angle, so you can understand precisely what it is you are putting your money in.
1. What Is an Annuity?
At its most basic, an annuity is a contract that requires multiple payments to be made at regular intervals over a period of time. However, when the average person thinks of an annuity, they refer to a life annuity in which an insurance company makes these payments to an individual or beneficiaries.
You sign a contract with the paying company that details how much you owe every payment period, as well as how much you will be paid and when the payments begin. Like many other financial commodities, annuities can technically be resold, though you may require specific certifications or clarifications in the contract to do so.
Used for their intended purpose, annuities offer one of many alternatives when planning for retirement to help ensure you have a steady income once you stop working. While many other retirement plans can involve significant amounts of risk, annuities offer a bit more stability– though some models can differ.
Keep in mind that even though annuities might often be managed like financial products, they are not investment security and do not follow the same kinds of rules as most other assets in this sector. Whereas traditional financial products fall under the SEC's regulation, annuities are regulated by the issuing state insurance board and not required to provide the same kind of transparency.
As a financial product, annuities come in many different arrangements, from paying in to paying out and every detail in between. It is recommended you work closely with a financial advisor before signing the annuity contract to ensure you understand explicitly what it entails as a general idea will not suffice in this instance.
2. How Does an Annuity Work?
This question is a bit tricky to answer as the plethora of different types of annuities can lead to very different answers, especially when it comes time to collect your payments. That said, the beginning functions similarly regardless of what type of annuity you purchase and starts with you making one or more payments.
Keep in mind; it is entirely possible to take a singular lump sum and put it into an annuity structure, which is one of the ways larger lottery prizes are paid out. Still, the more common type of annuity will see the holder pay into the annuity at a regular interval, generally monthly, but the contract can dictate a different schedule.
Likewise, the payment of the annuity's holding to you can also vary greatly, both in terms of the amount and the timing. Though, once again, the more common type of payment sees the issuer disperse a set amount of funds at regular payments, also often monthly but ultimately determined by the terms of the contract.
3. What an Annuity Is Not
Although the same company may issue annuities and life insurance plans, they are not the same kind of insurance product– confusion that has cost too many people a lot of money. Whether a fixed-term or a whole life insurance policy, this asset intends to ensure your dependents receive financial support following your passing.
While an annuity contract can include dependents as part of its clauses, this is not an inherent component of an annuity and carries additional fees. In its essence, an annuity pays out disbursements for the length of the contract or your lifetime, with the insurance company keeping any remaining payouts or principal should you die without a death benefit attached to the contract.
One of the main things to remember when getting an annuity is that it is not a great way to invest your money despite being a financial commodity. In fact, once the US Congress passed a law that requires brokers to act in their clients' best interests, annuity sales took a sharp dive across the board, with different types of annuities taking even sharper dives.
The main reason for this is not because annuities are liable to lose money but because they are unlikely to gain anywhere near as much on principle as other types of investment. This does not mean that annuities are terrible places to put your money, but if your primary concern is a return on investment, then annuities are not your best bet.
While they may seem somewhat similar in many external and internal ways, annuities are not a 401k retirement plan. For starters, annuities can be purchased by anyone, while a 401k can only be accessed by people whose employer manages one or is self-employed and starts one on their own.
A 401k will generally carry fewer fees for both the plan's general management and any administrative actions like early withdrawal. On the other hand, a 401k is closer to a traditional investment than an annuity and can generate higher yields but are not as reliable as annuities, which provide a guaranteed payout.
Like a 401k in comparison, an IRA shares some modest similarities with an annuity but ultimately differs more from it than it has in common. In fact, an IRA acts as an investment account which technically allows you to put your annuity, which is itself an asset, into it.
Still, annuities and IRAs both share the aspects that you have to open them individually for yourself, and they both share some tax-exempt statuses. However, annuities do not carry the same limits as to when and how much you can contribute to an IRA account.
There are different types of pensions, of which a 401k is one, but we are looking at a defined contribution or drawdown pensions for this point. Keep in mind, many types of pensions are provided either by an employer or through a governmental body, often with the flexibility of transferring the pension from one organization to another.
Technically, an annuity is another type of pension, but it’s classified as a defined benefit pension. One of the most significant differences between a traditional pension and an annuity is that the pension can run out depending on how much you put in and how much it generates. Still, it can also continue to generate value while payments are being disbursed to you.
While there are some similarities between the two, mutual funds are arguably more different from annuities than any other examples on our list. In fact, there are only a couple of different types of annuities that are similar to mutual funds because mutual funds tend to resemble general investments more than annuities.
For the applicable types of mutual funds, the main similarity between the two is that both can develop a solid investment strategy and carry more fees than some types of annuities. In terms of differences, the way fees are processed, and the taxes you pay for cashing out differ with annuities following income tax and mutual funds falling into capital gains taxes.
4. What Are the Types of Annuities?
As mentioned above, one of the more frustrating aspects of annuities is their complexity to the point that many account holders may not even be aware of what they can and cannot do or what does and does not payout. It is worth noting that many of the different “types” of annuities covered in the list below do not represent an exhaustive account, nor are they all mutually exclusive to one another.
In a traditional complicated manner, many of the different qualities that define an annuity contract can or require a mix and matching of these other “types.” However, we made it a point to cover many of the more common qualities you need to pick from when selecting an annuity to help you figure out the best combination.
Pay-in & Payout
An immediate annuity is arguably one of the more straightforward arrangements that focus on how you pay for the annuity and how disbursements are handled. Unlike most annuity contracts people take out, an immediate annuity sees you paying a larger lump sum into the principal that is then dispersed immediately over a period in smaller amounts to ensure it lasts for the time covered by the contract.
Immediate annuities are not uncommon, in general, but tend to be less common when it comes to individuals investing in their retirement.
This type of annuity often accompanies a particular circumstance, like an individual who opens an annuity when they retire or comes into a windfall but less for those who plan for their financial future and intend to pay into the annuity over time.
This is easily the most common type of annuity people purchase and covers more of the bases for what to expect when choosing among the different types below. Rather than paying a large sum into the principal and receiving payments immediately, you pay into a deferred annuity over an agreed-upon time (known as the accumulation phase) before the insurance company disperses the payments back out (known as the payout phase).
While it is technically possible to retrieve your principal before the contracted disbursement reaches its activation, you will pay a hefty surcharge for the privilege. However, it is also worth noting you can arrange a deferred annuity to pay out a lump sum once your contract begins disbursement – without suffering the penalty.
Still, once you lock into a deferred annuity contract, expect to stick with it for the long-haul as they are notoriously difficult to get out of.
5. Types of Fixed Annuities
This is the traditional type of annuity that most people consider when looking into the financial option to bolstering their retirement plans. That said, fixed annuities carry the lowest return rate compared to the other types, though they offer a bit more in terms of protection and annuity guarantees.
In terms of the return, a fixed annuity (as the name implies) provides a rate of interest returned on the principal as dictated by the contract without regard to the performance of the investments made by the insurance company's financial managers or the markets.
However, of all the annuities, a fixed rate annuity suffers none of the potential downfalls from a market taking a turn for the worse and will not see a drop in the payout amounts. On top of the reliability a fixed annuity offers, it also provides a bit more clarity with the contract as you do not need to consider market-based provisions.
That said, the guarantee of a fixed income may present some issues depending on the length of the payout period if the rate of inflation increases more than anticipated.
Equity-indexed annuities are your opportunity to get the best of both worlds when trying to balance between a higher rate of return on your investment from a variable annuity with the reliability of a fixed annuity. Technically, an indexed annuity is considered a type of fixed annuity, but the two differ enough for the annuitant to deserve its own examination.
Regarding return on investment, an indexed annuity differs from a variable annuity in how they invest, with the variable annuity investing in a much broader portfolio than an indexed annuity. As the name suggests, an indexed annuity ties the interest rate to a predetermined stock index's performance.
If the stock index performs well, the indexed annuity will see an increase in its growth rate, translating into higher disbursements during the payout phase. Of course, should the index not perform as well, you will not see as much growth as you would from most traditional fixed annuities but are unlikely to see complete stagnation as you could with a variable annuity.
Of course, the possibility of higher returns on investment come with similar higher fees as you would find with variable annuities compared to fixed annuities. Ultimately, an indexed annuity's primary benefit is that it helps protect you against a rise in inflation more than it is liable to see marked increases in investment.
Still, an indexed annuity is arguably a Goldilocks approach between fixed and variable models for those who plan to stick with their annuity for the contract's duration.
This is a type of fixed annuity that extends to the end of your life instead of covering a set amount of time and helps protect those you love. Unlike most other annuities, a lifetime annuity can cover up to two people and is one of the only financial assets that can be structured this way.
However, a lifetime annuity is not a death benefit and will not automatically pay out your principal's remainder to other beneficiaries, not named annuitants on the contract. It is worth noting that lifetime annuities are best suited for couples who have other plans for any beneficiaries and often provide smaller payouts.
Note: Variable Annuities
Variable annuities are about as close to investing in securities as you can get while still maintaining some of the traditional reliability you might otherwise receive from an annuity. Compared to the other types of annuities available, variable annuities also present a much higher chance of increased returns on your initial investment.
Of course, the ability to provide a higher return on investment also comes with a similar risk to your investment that you might otherwise have to shoulder in a traditional securities portfolio. To an extent, it is not a bad idea to consider a variable annuity in some ways similar to a mutual funds portfolio.
However, the variable annuity still differs enough in how you pay taxes on the annuity– specifically that the accumulation remains tax-deferred, but the payouts are taxed as ordinary income. One of the main benefits of a variable annuity is that you maintain a greater degree of control and flexibility over what your annuity invests in.
As an annuity, you can ensure your variable annuity includes all of the contingent riders you desire as you would other types of annuities for the same or similar fees. However, the variable annuity differs from other types in that the number of their payouts can fluctuate depending on the performance of the portfolio investments.
6. What Are the Benefits of Fixed Annuities?
By far, one of the most significant benefits of an annuity is you do not have to worry about incurring market losses to your principal investment the same way you do with most other types of investments. Granted, some types of annuities can impose a bit more risk than in general, but the assurance that your principal will not decrease still holds weight.
One thing to keep in mind is you also do not have to worry about a market downturn affecting your income payments since the annuity agreement tends to protect you from losses in the market. Keep in mind, the annuity may not draw as much in return when things are good, but the protection from a down market is still valuable.
Considering annuities are designed for retirement purposes, making sure you have enough money to last you the rest of your life is a paramount concern. By far, one of the best qualities of annuities is they ensure you will always receive some payment– so long as you do not withdraw early or otherwise enact any additional clauses of the contract.
This benefit falls in line similarly with the reliability benefit in the sense that you do not have to worry about how the market performs to know what you will receive. In combination, the reliability and regularity of an annuity form a potent protective measure that provides regular income through the rest of your retirement.
Rates of Return
This benefit is similar to the first two but differs slightly in terms of its application as it applies to the growth of your investment instead of the principal or payments. Keep in mind we will also include this quality in the drawbacks section following this list for different reasons, but the return rate can offer some benefit.
The main benefit of an annuity's return rate is that it can be guaranteed, meaning the insurance company will provide an increase in your return regardless of how the market performs. It is worth noting this rate tends not to be nearly as high as some of the other investment options in the market, but its guarantee can provide a sense of comfort to some.
While annuities are generally purchased during good times when you do not have financial difficulties, they are not always ideal when things turn sour. However, the same kind of dependability annuities afford throughout their development and disbursement continues when you run into financial difficulties.
Another great benefit of annuities is they cannot be seized or garnished by creditors as part of your assets– though this differs from state to state, so verify with your state ahead of time. It is worth reminding that this protection applies to most retirement accounts and does not extend to the IRS, which can still garnish annuities for delinquent taxes.
As discussed in the comparisons section, annuities share some tax-based benefits with other retirement accounts that make them attractive. In this instance, the fact you can pay into the annuity account with pre-taxed income is potentially a huge benefit. It not only plays into the annuity but reduces your taxable income.
When you consider an annuity does not impose a limit on the amount of the contributions you can pay into the account, this can be a great way to save money later. Granted, this also means you cannot deduct the money you pay into the account, and you will eventually have to pay taxes on the funds when disbursed.
While an annuity helps secure your retirement without worrying about a market downturn, you may also want to make sure your family remains cared for once you are gone. Thankfully, most annuities carry the option of including a death benefit. The beneficiaries included in the contract continue to receive your annuity payment even if you pass before they run out.
There are multiple types of death benefits that differ based on the type of annuity and the given clause of the contract, with some providing the amount contracted at the beginning and others potentially providing more. This may not be the best route for you to provide for those you leave behind, but it is one of many options to further care for your family.
Though a death benefit may be able to protect your loved ones from losing financial support upon your passing, that may not always protect them from the state. While you may intend to leave your loved ones with a nest egg to help them maintain their livelihood once you are gone, the government will likely take a rather large chunk of that aid in taxes.
This is where the annuity once again provides a sense of security and protection to help ensure that your loved ones do not have to worry. While the terms of estate probate differ from state to state, annuities are often a great way to help ensure that your loved ones have something reliable coming their way after you pass without having to worry about the state taking too big of a bite.
7. What Are the Drawbacks of Annuities?
Costs vary wildly depending on the type of annuity you purchase. Fixed annuities' costs are hidden and built into the product. They are not required to be disclosed.
Variable annuities, because they have securities inside them, fall under a different set of regulations. Those costs must be disclosed. Cost for variable annuities can run for the low end of under 1% to as high as 4% or more. Costs must be considered when looking at variable annuities. Like any other investment, costs can substantially impact returns.
Equity indexed annuities are a hybrid annuity with characteristics of both fixed and variable. They have yet another set of costs. Some of the costs are imposed upon surrender of the contract. Others are upfront.
The bottom line is this. Always check the costs and understand them before purchasing any annuity.
As alluded to prior, annuities have taken a bit of a hit since the US Congress passed a law requiring investment managers to work in their clients' best interest. Keep in mind, the main reason for this comes down to the clients' investment objectives, which are generally the highest returns within a given amount of risk.
If the highest returns stand as a priority for your investment portfolio, then annuities are not a great asset– regardless of the annuity you choose. Even those annuities that can offer a higher return on your investment tend to pale compared to most of the other securities available– though if you choose an annuity, it is almost certainly for the stability more than the returns on investment.
More than many other kinds of financial assets, annuities can be complex, often to the point that the contract holder or annuitant may not even understand the embedded and nestled terms. Even if you opt for a stock standard annuity model, there may be so much fine print that understanding what you can and cannot do with your annuity requires a skilled and experienced financial advisor to decode.
Of course, if you take that contract a step further by adding death benefits or any number of riders attached to the contract, the complexity grows. This complexity is by design. Many of the insurance company's salespeople do not genuinely understand how all rider-laden contract terms interact with each other and your potential decisions.
As much as annuities offer a sense of comfort through stability, they can also make you feel trapped should your circumstances change or decide you want to go a different route. With most investment securities, it is not difficult to move one type of asset into another to adjust your portfolio to better reflect your changing needs.
However, annuities are notoriously difficult to get out of with little wiggle room unless you are comfortable paying a high back-end surrender fee to get out of the contract's original terms. You might be able to move one annuity contract into another annuity contract; you will almost certainly be hit with another round of fees.
We will break this topic deeper a bit further later in the article, but taxes on an annuity can be tricky and do not often match up well with other types of investments. Granted, annuities allow you to take advantage of deferring your taxes on contributions made, but you still have to pay the piper in the end.
Part of the rub comes from the fact that, unlike most investment securities, annuities do not fall under the capital gains tax rates that tend to be comparatively low. Instead, most disbursements from annuities are taxed as ordinary income. Depending on the annuity type, it can be just as complicated when determining what is explicitly taxed.
As has been reiterated ad nauseum, one of the best qualities of an annuity is dependability. Still, there are certain instances when that reliability can fall through and leave you just as stranded as if you lost everything in traditional investments that go belly-up. In this instance, the potential concern comes from an insurance company that goes bankrupt and leaves you in the lurch.
Granted, this concern generally weighs more if you opt to take out an annuity with a smaller insurance company, but even larger companies like AIG can run into this issue. Depending on the type of annuity you hold, your state may guarantee the insurer to a point, but make sure you understand what your state will and will not guarantee before signing that contract.
8. What Are the Costs of an Annuity?
The costs of an annuity heavily depend on the type of annuity that you choose. Still, it should be understood ahead of time that getting into an annuity will carry with it higher fees than most other types of investment assets. Regardless of the type of annuity you choose, you will pay an annual fee to the insurance company to manage and administer the annuity.
However, this annual administration fee tends to increase the more you customize the contract with riders and other provisions or clauses. If you are not careful, a heavily customized annuity can carry riders that significantly increase the cost of fees to the point that they seriously begin to eat into whatever return on your investment you might otherwise receive.
Outside of the standard annual management fees and additional riders, variable annuities also tend to add investment management fees or expense ratio fees. When combined with the other fees noted prior, it is worth noting that these fees can add up in a hurry and make variable annuities the most expensive model.
Because of this, you should only consider a variable annuity with a relatively high cap rate that exceeds 10% unless you do not otherwise intend to attach riders to the annuity. However, even fixed annuities may charge fees as high as 4% of the account, depending on the specific number and type of guarantees associated with the contract.
Finally, the more hotly contested fee type is the surrender charge that annuitants have to pay if they want to remove some of the principal from the account before the payout phase begins. It is worth noting that while some annuity contracts have no option of getting any part of your money back before the term without paying a fee, others allow you to take a certain percentage as determined by the contract.
9. How Are Annuities Taxed?
This is a trickier consideration as the type of annuity you choose will impact how the annuity is taxed, but most annuities tend to have some consistent taxation qualities. For instance, one of the main selling-points mentioned prior is that payments made into your annuity are tax-deferred.
However, withdrawing funds from the annuity, whether through surrender or disbursement, incurs ordinary income taxes regardless of any capital gains made through the investment interest. For a traditional fixed annuity, this is not that big of a deal. Still, for indexed or variable annuities, the regular income tax is liable to be a higher rate than whatever you pay in capital gains tax on securities investments.
Another disappointing tax consideration is that even if you include a rider in your annuity contract that provides for your account's remaining balance to be paid to beneficiaries, they still pay a high tax rate. For instance, annuities cannot take advantage of the step-up basis that allows beneficiaries to pay taxes based on a readjustment.
Keep in mind, if you have a qualified annuity that uses pre-tax dollars and runs through a 401k or IRA, that is tax-deductible while non-qualified annuities are not. On the other hand, qualified annuities will require you to pay taxes on the principal once payouts begin. In contrast, non-qualified annuities only require you to pay taxes on the earnings of the annuity.
Regardless of whether your annuity is qualified or non-qualified, you will still have to pay the ordinary income tax on withdrawals and payments during the payout phase.
10. Is an Annuity Right for You?
Given that the rate of annuity contracts purchased dropped so precipitously following the now-defunct best interest law and the otherwise comparatively low rates of return, it can be tricky to know whether an annuity is right for you. More often than not, annuities are designed to supplement other retirement investments rather than supplant them.
If you have a 401k or IRA, you should generally pay into those accounts as much as possible before considering an annuity. Of course, those accounts tend to have rather hard cap limits on how much you can pay into them, which is where an annuity that has no contribution limit comes into play.
Keep in mind, if you are looking for the highest rate of return on your investment, an annuity is still likely not the best option for you– even once you max out your other retirement accounts. However, if one of your primary concerns is the dependability of payments once you retire, regardless of the market's performance, then an annuity may be right for you.
As we can see, annuities are just as complicated as any other kind of financial asset and arguably more so when you consider their contract structure and tax status. Aside from the plethora of options annuities offer, they will not fit everyone's preferences or needs equally and are best reserved for those who favor reliability over return.
That said, the sheer complexity of annuities, while daunting at first, also means that you can set up an account that fits your needs like a glove and offers a customized solution for your retirement that may be difficult to find elsewhere. Of course, the contract's strict terms may be malleable and easy to get into, but you need to have a visionary idea of your future needs, given that they are difficult to impossible to get out of.
Above all else, we strongly recommend that you consult a financial professional before considering an annuity and stressing this kind of asset's possible reliability if you genuinely are interested in one. Annuities may not be right for everyone, but they might be right for you for those who pretty much have everything else.
Michael launched Wealth of Geeks to make personal finance fun. He has worked in personal finance for over 20 years, helping families reduce taxes, increase their income, and save for retirement. Michael is passionate about personal finance, side hustles, and all things geeky.