One of the most significant problems people face when saving for retirement is not investing enough money. The last thing you want to do after spending your entire adult life working, is to run out of money during your retirement years. Unfortunately, this issue is all too common, as many people underestimate how much money they’ll need to live comfortably without working for the rest of their lives.
Currently, only about 25% of Americans save enough money for retirement. Some people overestimate how much they’ll receive from Social Security, while others expect their 401(k) or individual retirement account (IRA) to stretch further than it actually will. Some people simply underestimate their retirement expenses or outlive their own expectations for longevity.
No matter the underlying reasons, not saving enough for retirement can be a burden for the rest of your life. Not only can this decrease your standard of living, but it can also leave loved ones struggling to pick up the slack. Thankfully, there are solutions that can prevent these issues from ever arising in the first place.
Annuities are a great way to fill in the gaps in your retirement portfolio. With an annuity, you can set up a guaranteed income stream that lasts for the rest of your life. However, it’s important that you choose the right kind of annuity, as not all of them are created equal.
To begin, we’ll take a quick look at the basics of annuities. While often grouped in with other types of common retirement investments — like 401(k) plans or IRAs — annuities have some crucial differences. For starters, you actually purchase annuities from insurance companies, rather than opening an account with a brokerage, as you would for an IRA, for example.
While this might seem unusual, it makes perfect sense when you consider that an annuity has quite a few common characteristics with insurance policies. In fact, you can think of an annuity as a sort of insurance policy providing coverage against running out of retirement funds. One of the best attributes of annuities is that they don’t have strict contribution limits like 401(k)s or IRAs. You can only contribute $19,500 per year to a 401(k) and $6,000 to an IRA. If you’re 50 or older, those limits expand to $26,000 for 401(k) plans and $6,500 for IRAs. However, an annuity has no such limits, so you can feel free to invest as much as you’d like.
Like a 401(k) or IRA, the money earned in an annuity is tax-deferred. In other words, you won’t owe any taxes until you make your first withdrawal from the annuity. With a life annuity, you will receive a guaranteed monthly payment on a regular basis from retirement age (typically defined as age 59 ½) until you pass away. It doesn’t matter if you live until you’re 61 or 111 years old — you will receive an annual payment every year.
However, there are many annuities that only provide income for a set number of years. For instance, a period-certain annuity only provides payments for a predetermined period. Typically, these annuities provide guaranteed payments for at least a decade, and you’ll often find period-certain annuities with 20-year structures as well. Still, it’s important to point out that these annuities do not provide a guaranteed lifetime income stream.
As it turns out, there are several different types of annuities available, but only the life annuity offers policyholders the safety net of guaranteed payments for life.
We’ve already established that the life annuity provides regular income until you die, but there are quite a few variables involved. Depending on your needs and preferences, you may prefer a traditional life annuity or one of its related annuity types.
Let’s start with a discussion of what a typical life annuity looks like. If you’re concerned about not saving enough money for retirement in your 401(k) or IRA, a life annuity provides the peace of mind that you will not outlive your retirement savings. Life annuities are purchased with an upfront lump-sum deposit or a series of annual or monthly payments. Additionally, you usually have some options regarding how your payouts are structured, what happens to the rest of the money if you pass away earlier than expected, and other variables.
When do you need to start receiving payments? If you’re already retired, you might want to look into an immediate annuity. While the word “immediate” is often open to some interpretation — there is often a nominal wait period of a few months before your first withdrawal — these annuities allow you to start taking payments soon after you purchase them.
If you choose an immediate annuity, you will likely purchase it with a lump sum. Your insurance provider will calculate how long they expect you to live, the interest rates available to them, how much money they will provide each year, and more. Once your insurer comes up with a quote, you can buy the annuity and start taking advantage of its tax-deferred payouts nearly immediately.
On the other side of the coin are deferred life annuities. A deferred annuity often includes the option to pay in an upfront lump sum or in a series of premiums, much like the premiums you pay for an insurance policy. As the name suggests, you usually purchase a deferred annuity before you retire, with the goal of beginning your withdrawal payments sometime after you turn 59 ½ years old. In the meantime, your annuity earns interest in a tax-deferred manner, just like your 401(k) and/or IRA does.
One important factor to understand is that whether you choose an immediate or deferred payout structure, the underlying foundation of the life annuity is largely the same. With either one, you can contribute as much money as you’d like each year, with no limits like you’ll find with a 401(k) or IRA. In addition, both deferred and immediate life annuities offer guaranteed income streams for the rest of your life. The only significant differences are how you pay for them (lump-sum vs. premium payments) and when they start paying out.
Another crucial choice to make is whether you want your life annuity to grow at a fixed or variable rate. The fixed life annuity is a simple structure that provides a predetermined interest rate for your funds. During the accumulation phase of your life annuity (the years before you start taking withdrawals), the annuity will grow at a fixed rate, regardless of any underlying market conditions.
Even after you reach the annualization phase (when you’re receiving your regular payments), the balance of your account will still earn interest at this same rate. This is why fixed annuities are so popular. The amount of money you receive from them is entirely predictable, and there are rarely any surprises with a fixed annuity. This makes fixed life annuities a perfect supplement to your traditional retirement accounts.
Meanwhile, variable annuities rely on market conditions to determine your rate of return. Because that rate can increase or decrease throughout the life of your annuity, your payouts are not as predictable. However, if you can be a bit more aggressive with your investments, the variable life annuity can be a smart purchase.
If you’re not yet nearing retirement age, you might be more willing to subject your annuity to the market’s upturns and downturns. Similarly, people who already have plenty of retirement funds — and only intend for the annuity to provide supplemental or backup income — may prefer a variable annuity. After all, if market conditions are favorable during the accumulation phase of your annuity, you will likely end up with larger payouts than you would if you had chosen a fixed annuity.
Depending on your exact situation, you may prefer either a fixed indexed or registered index-linked annuity to the more popular fixed and variable options. Both of these annuity types guarantee minimum annual payments while providing more growth potential than a fixed annuity. Generally speaking, the fixed indexed annuity has higher guaranteed returns and lower growth potential than a registered index-linked annuity.
In terms of risk, from most conservative to most aggressive, the four options line up like this:
Another major choice you’ll need to make when purchasing your life annuity is whether you want a qualified or non-qualified version. The difference is rather simple. You buy a qualified life annuity with money from a traditional retirement account. This means you’ll need to pay taxes on your distributions because those funds were never taxed to begin with.
Meanwhile, a non-qualified life annuity can be purchased using money you’ve already paid taxes on. Therefore, you will only ever need to pay taxes on the earnings you receive throughout the annuity’s lifecycle.
However, it’s important to note that taxes for annuities can become quite complicated, beyond simply choosing a qualified or non-qualified annuity. There are too many taxation variables for us to dive into the specifics here. Still, you should know that annuities can have severe tax penalties if you withdraw any money before you reach retirement age (59 ½ years), whether your annuity is qualified or non-qualified.
With any annuity, it’s vital that you ensure you won’t need to withdraw any funds before reaching the annualization phase. Early withdrawals carry tax penalties that can make annuities poor investments if you can’t afford to wait long enough for your payouts.
What if you want to provide lifetime retirement income for you and your spouse? With a joint life annuity, you will receive a life annuity that covers you both. When one-half of the couple passes away, their partner continues receiving guaranteed payments for the rest of their life. The amount of these payments remains the same whether both people are alive or if one of them has passed away.
If you’re concerned about your spouse’s ability to maintain their standard of living after you’re gone, a joint life annuity is an excellent way to provide coverage for both of you. Some of these plans even allow you to designate a third person who will take over the payments if both you and your spouse die.
As you can see, there are several different ways that an annuity can provide a guaranteed lifetime income stream. In fact, the many varying options for purchasing and withdrawing your life annuity are part of why annuities have become so popular in the first place. No matter what your situation looks like, there’s a form of life annuity that fits your needs.
In general, a life annuity can help you properly plan for a fulfilling and enriching retirement. Especially considering how many Americans save too little for their golden years. You can never be too certain that you have sufficient funds waiting for you in retirement. Thanks to the lack of annual contribution limits, annuities help you make sure you have a large enough safety net to keep you thriving throughout your retirement, no matter how long you live.
Still, you should make sure you purchase the right kind of life annuity for your needs. Choosing the proper level of risk in the context of your overall retirement portfolio is always important, as is the decision to select an immediate or deferred payout structure. As long as you understand the details of the different types of life annuities, you should be able to find one that fits your circumstances.
If you have any further questions about how annuities can provide guaranteed income for life, ask your independent insurance agent for more information. They can help you analyze your situation and find a suitable annuity.