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401(k)s, IRAs and pensions are all familiar parts of a retirement savings portfolio—but annuities also offer a steady stream of income after retirement. Find out if an annuity should be part of your retirement savings strategy.
As with any investment strategy, it’s a good idea to diversify your retirement savings portfolio. One way to do this is to include an annuity along with your other retirement savings options. An annuity is an insurance product that pays you income based on an agreed contract.
Annuity investment and payout options
There are two basic types of annuities (deferred or immediate) and two ways that annuities can be paid out (fixed or variable). The type of annuity you invest in typically will depend on your age.
A deferred annuity can be purchased prior to retirement and enables your funds to grow until you begin making withdrawals. An immediate annuity is usually purchased close to retirement age and you’ll begin receiving income soon after your purchase.
You also have a choice between payout options. You can choose to receive a guaranteed payout (a fixed amount) or a payout that is determined by the performance of your annuity’s investments (a variable amount). If you choose a fixed annuity, the investment company will determine how your money is invested; with a variable annuity, you can choose which funds to invest your money in.
Advantages of an annuity
The main advantage of an annuity is that it provides you with a steady stream of income during retirement. Additional advantages include:
- Tax-deferred savings
- Access to a range of funds for your investment
- No contribution limits (unlike 401(k) or IRA plans)
- Tax-free growth
- A death benefit is offered with many annuities, which means that your designated beneficiary will receive your annuity payments should you die.
- The ability to exchange your existing annuity for a new one—known as a 1035 exchange after the section of the U.S. tax code that enables it. However, this should be done with caution as you may face surrender changes (described below) and other fees.
Disadvantages of an annuity
The main disadvantage of an annuity is that they often come with high fees. (Sometimes adding up to 2 percent to 3 percent a year, which can be more than double the fees you’d pay with a mutual fund.) Additional disadvantages include:
- There are commissions to be paid to your broker (unless you purchase a direct-sold annuity).
- Surrender charges will apply if you pull money out of your annuity within the first few years, as specified in your contract. (These can run around 7 percent for the first year, with the percentage dropping year after year.)
- The investment company you’ve invested with may go out of business. To help insure against this, be sure to check the company’s credit rating (which you can do through A.M. Best or Moody’s) and limit your options to insurers with an AA- or higher rating.
Withdrawing money from an annuity
When it does come time to start receiving payments from your annuity, you will need to pay regular income tax on your investment earnings. (And if you make withdrawals prior to age 59½, you’ll have to pay a 10 percent early withdrawal penalty.)
Ask before you buy
Before purchasing an annuity, be sure to talk with a tax and financial advisor. You also want to make sure you understand what you’re purchasing, so be sure to ask the insurance broker:
- To cover all fees involved in maintaining and surrendering the annuity
- How your funds will be invested
- What additional options are available to purchase with the annuity
Most annuity contracts have a “free look” period of ten days or more. During this time you can continue gathering information. If, at the end of the period, you decide the annuity is not right for you, then you can terminate your contract without paying any surrender fees and receive back any investment you may have already made.
This article contains general information. Individual financial situations are unique; please, consult your financial advisor or tax attorney before utilizing any of the information contained in this article.
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