One of the biggest challenges with retirement is creating steady, reliable income each month for the rest of your life. There are multiple unknowns: From investment returns, the economy, to longevity and health, all can alter the amount required to live comfortably in retirement.
Choosing investments, from stocks to CDs, can carry risks ranging from account fluctuation to growth uncertainty. Choosing the right investment for your needs can be as important as putting money away in dedicated retirement accounts.
Annuities are an investment option that come with certain guarantees many seniors find attractive: They allow for market investment options to increase growth opportunities and offer a safety net to protect against market declines. While they may appear complicated, they are designed to take some of the uncertainty out of your investment portfolio.
Here are the key factors you must understand about annuities before investing.
What are annuities?
Insurance companies offer annuities as a form of tax-deferred insurance with payouts in retirement. After choosing a policy based on your goals, you may fund it all at once or through monthly payments. Annuities also allow you to invest based on your comfort with risk. Investments can use pre-tax or after-tax dollars, and grow tax-free, giving you faster account growth until retirement.
Annuities come in two phases: the accumulation phaseand the payout phase. In the accumulation phase, you will add money to your account and the funds grow based on your investment selection. When you are ready to retire, or need the funds, you may convert the account to the payout phase. At that time, you are no longer able to add new money. During the payout phase, you can establish guaranteed income for your lifetime, regardless of how long you live, giving you a pension like payment.
The Four Components of Annuities
- The insurance company will guarantee the policy or contract and manage the account.
- The annuity owner buys the contract and has the right to any cash surrender value. The owner also chooses beneficiaries, controls withdrawals, and may assign the policy to someone else. At the time of payout, the owner receives the funds and pays any taxes due.
- The annuitant is also the insured. The policy is in the name of the Their age determines the life expectancy and policy terms. Most often the owner and annuitant are the same.
- The beneficiaries are those who receive death benefits when the annuitant passes away.
Immediate and Deferred Annuities
Immediate annuities do not have an accumulation phase, and payout begins immediately. The annuitant or policy owner makes a single contribution which converts into a payout based on the annuitant’s life expectancy and the payout option chosen.
Deferred annuities consist of payments over time and the ability to accumulate larger balances, due to account growth. During accumulation, you may choose investments and add contributions at any time. The account grows based on market performance or the set rate offered by the policy.
During the accumulation phase, the owner may make withdrawals.There may be fees and taxes based on how long the money is in the account and the age of the annuitant. The policy owner also may surrender or cancel the policy, exchange it for another, or convert it to a permanent income stream.
Fixed Annuities Versus Variable Annuities
Fixed annuities offer guarantees from the insurance company. You select a timeand they offer a set rate. It works similarly to a bank CD. At the end of the initial period, the rate resets based on current market conditions. You may move the annuity at that time to take advantage of the best rate available. Fixed annuities are best for those wanted predictable rates of return and minimal volatility on the account. The risk is that you will not gain high enough interest to outpace inflation.
Variable annuities offer higher potential returns with more account volatility, much like a mutual fund. Policies operate like a retirement account and must remain in place until 59 ½ to avoid a penalty. You choose from a selection of investments offered by the insurance company and can adjust among those choices at any time. Variable annuities work best when you make regular contributions and are willing to accept an increased risk for potentially higher returns.
Investors are attracted to variable annuities because they also come with guarantees, not offered in a traditional mutual fund or 401K. For example, a policy might guarantee the investor a minimum return, minimum growth thresholds during the contract, or promise adjustments determined by account performance. Adding safety nets through guarantees cost extra, which does make an annuity more expensive than a traditional mutual fund, impacting overall returns. For some, that is a small price to pay for greater peace of mind.
Options for Payouts
When converting to the payout phase, also called annualization, you may choose monthly, quarterly, semi-annual or annual payments. You then select from the payout choices below:
Income for Life will give you a set amount each month the rest of your life. This option is the highest payout and ensures you will never run out of money. There are no survivor benefits should you die early.
Joint Survivor is best for spousal accounts because you set up payments based on the youngest person’s life expectancy and receive payments until the last person dies. It offers a lower payout each month, but covers two lifetimes. There are no survivor benefits.
Guaranteed Time Benefit pays a certain number of payments, which typically range from 5 to 30 years. There is a set amount paid, and if you die early, survivors receive any remaining payments. Sometimes, payments will adjust for inflation. You may outlive the payments on this option.
Income for Life with Guaranteed Certain makes payments for your life or a set minimum number of years. This option protects against early death, but also guarantees payments for life.
Qualified Versus Non-Qualified Accounts
A qualified annuity makes contributions with pre-tax dollars and typically results from a transfer from an IRA or 401K. All funds are taxable at the time of withdrawal and must remain in the account until 59 ½ to avoid an early withdrawal penalty.
A non-qualified annuity uses after-tax contributions. You do not get any initial tax benefit, but the money grows tax-free. At withdrawal, you owe taxes on the account increase.
In addition to the early withdrawal penalty, there are also annuity schedules that may result in surrender fees if withdrawn within the first seven years. Accounts may also restrict withdrawals to a certain number each year and a percentage of the balance.
Some investors use a systematic withdrawal, to keep funds invested longer, instead of converting to a lifetime payout. You would gain reliable income, but lose some of the lifetime payout guarantees. In this case, you have more control over withdrawals and heirs receive any remaining funds in the account.
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