Should I Invest in an Annuity?
May 11, 2023
Blueprint Income Team
If you're wondering if you should invest in an annuity, let's first clarify something: An annuity is not your typical type of investment — instead, an annuity is a long-term contract between you and an insurance company. Some annuities do have investment-like qualities, which can create some confusion.
Annuities can be a great financial product to consider when planning your retirement, especially when you use them in coordination with other financial products. Learn what an annuity is, what payouts and costs to expect, what income options and riders may be available, and how to choose the right one for you.
Should I buy an annuity?
Whether or not you buy an annuity depends on your tolerance for asset risk as well as your desire for protecting your assets and avoiding the risk of outliving your money. An annuity may be a good choice if you want to add lower-risk financial tools to your portfolio, with the ability to turn your funds into guaranteed income for life or a certain period of time.
An annuity is a financial product that offers guaranteed income, typically once you retire, but it can be before. How much you can receive from an annuity depends on a few factors, including the value when you “annuitize” (start receiving income), type of payout — variable or fixed rate, and whether you choose lifetime income, income for a fixed term (like 10 years), or a combination of the two.
Whether you have a single or flexible premium annuity can also factor into payouts and costs. For example, a single premium annuity only accepts a single payment. A flexible premium annuity allows you to make multiple installments over time.
How much does an annuity cost?
Annuities are considered a low to moderate risk compared to typical investment vehicles like stocks or bonds, but it's still important to be aware of the costs. Here are a few possible costs to consider before buying an annuity:
Fees: In general, fixed deferred annuities and various types of income annuities do not impose fees. Conversely, variable annuities often involve administrative expenses and additional fund fees. These fees can be calculated as a percentage of your total contract value or as a flat fee on a monthly or annual basis.
Potential penalties: Annuities may have significant surrender fees and penalties for ending your contract or taking excess withdrawals not allowable under the contractual terms. The IRS may also charge a 10% tax penalty for withdrawing from your annuity before you turn 59 1/2 years old.So, it’s important to consider when you'll need to access your funds, as a surrender charge and/or tax penalty may apply.
It's also important to consider that many annuities have minimum funding requirements of $5,000 or more.
Tax implications of owning an annuity
One of the primary advantages of annuities is the tax deferral that deferred annuities provide on non-qualified assets, so you won't have to pay taxes on your earned money until you withdraw the funds. The amount of taxes you pay when you withdraw your money or start receiving income depends on whether you funded your annuity with pre-tax or post-tax dollars. Some people may also qualify for a lower tax bracket once they reach retirement age, which can reduce tax liability since annuities are taxed as ordinary income. Also, if you choose an income option that provides income to a beneficiary upon your death, they may also be responsible for paying taxes on those payouts.
As long as you prepare for your tax liabilities when planning retirement, you can account for taxes while taking advantage of reliable monthly payments from an annuity. Working with a financial adviser can help you calculate how much you'll likely owe in taxes when taking income payments or withdrawals from your annuity.
Additionally, if you purchase your annuity with post-tax funds, you'll only be responsible for income taxes on your earnings at the time of withdrawal. This means you can withdraw your initial contribution tax-free, and the earnings you receive are taxable at your ordinary income rate, which is the tax bracket you fall into based on your earnings for that taxable year. Note that withdrawals are considered earnings first, and contributions second.
How to choose the right annuity
It's also important to conduct research before you choose the best annuity type for you. You want to choose an annuity that fits your financial goals and comes from a reputable insurer. Make sure the insurance provider backing the annuity is financially sound and highly rated.
The two major annuity types are accumulation and income annuities. Accumulation annuities can be fixed, fixed-indexed or variable. Fixed annuities credit a guaranteed interest rate and protect principal. Fixed-index annuities credit interest based, in part, on a market index while protecting principal. A variable annuity provides returned based on the market's performance during your accumulation period. Both fixed and variable annuities can be annuitized during the accumulation phase to provide lifetime income.
With income annuities, you can choose between immediate and deferred. With an immediate annuity, you invest a sum of money and start receiving guaranteed income right away. With a deferred annuity, you specify a point in the future (e.g., 10 years) to start receiving your guaranteed income.
Do you need guidance in deciding whether to purchase an annuity? This useful guide not only helps you decide if an annuity fits in with your retirement goals but also helps you choose the best type.
Blueprint Income Team
We are a team of finance, insurance, and actuarial professionals working to make it easier for everyone to achieve a steady and comfortable retirement. We write about annuities (the good and the bad) and provide strategies to help Americans prepare for retirement.