How Do Annuities Work?
While there are different types of annuities, it’s really a simple concept. You invest a sum of money with a reliable insurance company. Set a date for when you want payments to start. And then you receive regular payouts for the life of the annuity.
Main Types of Annuities
While the types of annuities generally follow the same process, some annuities work differently than others. The two main types of annuities are deferred and income annuities. A deferred annuity is an annuity that you fund, but don’t start receiving payments until a later date. Most deferred annuities allow you to defer as little as one year or as many as 50 years.
Benefits of Deferred Annuities
- Deferred annuities are beneficial if you don’t have a lump sum of money equal to the amount you need over time. For instance, if you need a $200,000 annuity starting in 5 years but don’t have all $200,000 now, that’s ok! You could invest in the deferred annuity over the next 5 years to equal $200,000, and then start receiving your full payments.
- Deferred annuities are also a safer way to continue investing after retirement. This is because your money is immune from market fluctuations.
- Another positive thing about deferred annuities is that they often have a death benefit. This means that your loved ones would be paid back the full amount remaining in the annuity in the event of your death. The payout is typically what is left of your original investment. If you invested $50,000 and received payments for $40,000, $10,000 would be left for your loved ones. Unlike life insurance policy payouts to beneficiaries, annuity payouts to loved ones will be taxed.
Annuities can be structured differently, so talk to a professional to get a full understanding of what happens with your chosen type of annuity when you die. Make sure to have this conversation with your agent/producer, because some annuities do end upon your death.
Income annuities differ from deferred annuities because the payout is immediate. Income annuities are typically purchased in a lump sum. This type of annuity usually pays out monthly for the remainder of your life. Some income annuities have joint options. With a joint-life annuity, your spouse will continue receiving payments for the rest of his or her life after your death.
Because 401(k) balances can be rolled into income annuities with no tax penalty, it is often an appropriate strategy for someone nearing retirement. By rolling some of your retirement funds into an income annuity, you can receive monthly payments for the rest of your life, helping to ensure your retirement stays funded. Be mindful when choosing how much retirement money to invest into an annuity — once you fund an annuity, you can only receive the scheduled payments and cannot withdraw funds for emergencies without a penalty.
Risks of Annuities
While circumstances may deem annuities a good fit for you, there are certain risks you should make sure you understand.
- Annuities are not a flexible investment option. Once your money is invested and your payout structure is scheduled, you cannot retrieve your lump sum without paying a surrender fee. And if your lump sum grew while in the annuity, you will face a tax penalty on the growth when you make your withdrawal.
- Annuities are low risk in terms of market volatility but have less growth potential. Many annuities grow at a fixed rate, meaning that your potential return on investment is lower than it would be had you invested in other assets or opportunities, like stocks.
- Annuities are paid out based on the ability of the insurance company. This makes it vital to choose a company with a good reputation and long-standing success. If the company you purchased your annuity through goes bankrupt, your investment may not be paid.
- Inflation should be considered when investing in an annuity. An annuity will pay the same monthly income to you in 2018 as it will in 2038. Some annuities offer inflation protection that increase annuity payments as the years pass by, but it can drastically reduce your payments early on.
Which Annuity is Right for You?
Deciding which annuity is right for you can be determined by talking to a professional or by weighing some options yourself. For example, if you want monthly payments to continue even after you retire from your job, an income annuity might be an appropriate strategy to help secure your financial future. But if you are confident in your savings and don’t want guaranteed monthly payments until your 80th birthday, maybe a deferred annuity would be best.
Annuities are considered to be a safer long-term investment that can help ensure you don’t outlive your retirement funds by providing dependable income over time. This makes annuities a useful strategy for a wide variety of people with different financial circumstances.
If you’re looking to help secure income in retirement or planning to retire early, annuities may be an appropriate financial strategy. Talk to an agent/producer to see if an annuity is the right fit for your retirement strategy or financial needs.
Consult with a professional tax and/or legal advisor before taking any action that may have tax or legal consequences.
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