Saving for retirement can be a stressful process. How much money do you need? How many years do you need to plan for? What happens if you run out of retirement income? While these can be nerve-racking questions to consider, there are ways to prepare for retirement in a relatively worry-free manner. Specifically, annuities provide retirees with guaranteed, regular income that lasts for as long as you live or until the contract expires, depending on which type of annuity you buy.
But what exactly is an annuity? And should you consider integrating annuities into your retirement plans? In this article, we’ll discuss all of the relevant details of annuities and explain the role they can play in your overall retirement plan.
According to research published in December 2018 (and revised in February 2020), a full 75% of all workers save too little money for retirement. That’s why annuities have become so commonplace. You can purchase annuities from your life insurance provider, and they provide a set amount of income for the rest of your life (or for a fixed number of years) after you retire.
Much like an IRA or a 401(k) plan, annuities have tax-deferred growth, so you won’t pay a dime in taxes on this money until you start withdrawing it post-retirement. How much your funds grow relies largely on whether you choose fixed or variable annuities. With a fixed annuity, your investment will earn interest at a set rate. This rate is determined ahead of time, and it will not change. On the other hand, variable annuities are exactly as they sound: the amount of interest you earn is directly linked to current market values.
There are also a few less-popular forms of annuity, aside from fixed and variable. Depending on your insurance company, you could also have access to fixed indexed, registered index-linked, or immediate annuities. A fixed indexed annuity guarantees a minimum downside payment while still having growth potential. A registered index-linked annuity is quite similar to a fixed indexed annuity. The main difference is how it shifts your risk — registered index-linked annuities typically provide higher growth potential but lower guaranteed returns. Finally, an immediate annuity starts paying out either immediately (as the name implies) or within a short time period, usually one year.
No matter which one you choose, annuities pay out each year until you die or the annuity expires (more on this shortly). If you happen to pass away before the annuity expires, some types of annuities allow you to pass them on to a loved one in your last will and testament. If you hope to pass on your annuity, you will need to make sure you select the right type. In the next section, we’ll discuss all of the important details.
There are three main styles of annuities. Depending on your circumstances, you might prefer either a period-certain annuity, a life annuity, or a life with period-certain annuity. Let’s briefly walk through these three annuity types and consider which one best fits your retirement planning goals.
This form of annuity includes guaranteed payments for a certain time period. Most period-certain annuities (also commonly known as fixed-period annuities) last for 10–20 years. If you die before the annuity starts paying benefits — or if you pass away before the insurance company makes all payments — you can usually transfer the payouts to a loved one. However, if you live longer than the time period specified in the annuity, your payments will end.
A life annuity is precisely how it sounds: this annuity guarantees annual payments for the rest of your life. That’s right, even if you live to see your 123rd birthday, becoming the oldest person who ever lived, you will still receive the same amount of money each year. If you die before you start receiving payments, you can designate a beneficiary to receive a lump-sum payment. With life annuities, you can also purchase a joint plan for you and your spouse, which we’ll discuss in greater depth in a bit.
Finally, we reach the life with period-certain annuity, which works as a sort of hybrid between a life annuity and a period-certain annuity. These annuities have a fixed period just like period-certain annuities do, but there’s a stipulation that if you die before that period is up, the insurer will instead make those same exact guaranteed payments to your beneficiary until the end of the time period.
As with any investment, purchasing an annuity has some pros and cons involved. Depending on your financial situation, there could be other options that better suit your goals. If you have any questions, it’s always best to discuss them with a reputable financial advisor. That said, let’s run down some of the basic advantages and disadvantages of purchasing annuities for retirement planning.
The most noteworthy advantage for annuities is the way they provide guaranteed income throughout the term of the agreement. If the uncertainty of a traditional retirement plan doesn’t appeal to you, annuities offer a tremendous amount of peace of mind. There is no better way to secure guaranteed annual payments for your retirement years.
One issue with 401(k) plans and IRA accounts is the fact that there are limits to how much you can invest in any given year. With a 401(k), you are only allowed to contribute $19,500 per year — unless you’re at least 50 years old, in which case you can contribute a maximum of $26,000 each year. As for IRAs, these accounts are even more restrictive, with contribution limits of just $6,000 per year (or $7,000 if you’re 50 or older).
Meanwhile, there is no contribution limit for an annuity. Even for people with traditional retirement accounts, an annuity can be an excellent way to invest any additional funds you’re not allowed to contribute to your IRA or 401(k) once you hit your investment limits.
An annuity has several common characteristics as life insurance, and they’re sold by the same companies. In this regard, annuities can be used as a supplement to your life insurance policy, or even as a replacement. Obviously, one significant difference between an annuity and a life insurance policy is that the policyholder can enjoy guaranteed income for life through the annuity. In contrast, only the policyholder’s loved ones will receive money from a life insurance policy.
However, if you’re concerned about the financial health of your spouse after you’re gone, an annuity can serve a similar purpose to life insurance. As we briefly mentioned earlier, you can accomplish this by purchasing a “joint income for life” annuity, which provides guaranteed lifetime income to both individuals in a married couple. When you die, the other person on the policy continues receiving payments until their death.
While annuities have plenty of advantages, there are some areas of concern as well. For the most part, these issues revolve around the fact that annuities can have some rather steep fees associated with them, which you can at least somewhat avoid with other forms of retirement investments.
First off, you might be subject to a high upfront commission fee when you purchase an annuity. This is due to the annuity being sold by life insurance companies, which means there’s a sales agent somewhere who receives a significant payday in exchange for selling you the annuity. As you might expect, that fee typically comes out of your pocket in one way or another.
Annuities also sometimes have very high surrender fees. If you own an annuity that you need to liquidate before you reach retirement age (which is defined for these purposes as 59 ½ years old), you will subject yourself to a myriad assortment of taxes and fees. The Internal Revenue Service (IRS) will take its cut first, to the tune of 10%. In addition, the insurance agent who sold you the annuity will charge you a fee of up to 10%. The IRS does allow you to transfer your investment from one annuity to another without any financial penalties, but this is the only exception.
While your money grows in a tax-deferred manner in an annuity, any withdrawals before retirement are also subject to capital gains taxes. This means that funds withdrawn from your annuity before you turn 59 ½ will be taxed the same way as any stocks, bonds, real estate, or property you sell. Because most annuities are held for more than a year, these withdrawals would be taxed by a rate of up to 20%.
For most people, this rate will be 15%. The long-term capital gains tax rate for people making less than $40,000 per year is 0%, while the rate for people making more than $441,450 pay 20%. Everyone in between pays a 15% tax. Therefore, as with all retirement investments, it’s best to not touch a penny of your annuity before you actually retire!
One of the most common annuity questions we hear is how qualified annuities differ from non-qualified annuities. A qualified annuity is one purchased using money from a 401(k) or IRA — in other words, you can buy a qualified annuity using pre-taxed money. On the other hand, a non-qualified annuity is purchased using money that has already been taxed and does not come from a retirement plan.
Why does this matter? Non-qualified annuities have no investment cap, while qualified annuities are subject to IRS retirement investment limits. Another major difference is that qualified annuities require you to start withdrawing your annual payments by the time you turn 70 ½ years old. As for non-qualified immunities, there is no age-based distribution requirement.
In general, there are several different situations in which an annuity could be a wise investment. One such situation is if you regularly max out your 401(k) and IRA investments. In this circumstance, the annuity is one of the few remaining avenues for you to save money for retirement using tax-deferred means.
Annuities are also a great option for people who expect to live for a long time. If people in your family typically live into their nineties — without complications from cancer, heart disease, and other common ailments — an annuity can help ensure that you don’t run out of money due to living longer than you thought you would. While living too long might seem like a good problem to have, no one wants to spend their twilight years pinching pennies, unable to continue the same standard of living you had for most of your adult life.
Finally, if you’re concerned about your spouse running out of retirement funds after you die, a joint life annuity can provide the peace of mind you need. This way, no matter which one of you passes away first, the remaining partner will live a financially comfortable life for the rest of their days.
Saving for retirement is one of the most important financial goals in any person’s lifetime. Failing to properly plan for your post-retirement financial situation can not only prevent you from living the “golden years” as you may have envisioned them, but it can also place a tremendous burden on your loved ones as they try to provide you with the dignified retirement that you failed to plan for yourself.
It’s not typically advisable to solely invest in annuities as your retirement nest egg, but annuities are an excellent choice as a supplemental investment. Once you’ve reached your contribution limits for your 401(k) and/or IRA, investing in an annuity can provide the same tax-deferred benefits with no maximum amounts.