Purchasing an annuity is one way to earmark money for your retirement. But these financial products can be complex. Make sure you understand the basics, including costs, fees, types, payout options, inheritance and taxation.
General Annuity FAQs
An annuity is a customizable contract between you and an insurance company. You pay a lump sum or series of premiums in exchange for a guaranteed fixed income stream from the insurer.
Payouts from the insurance company can last for a specified time period or the rest of your life. Annuities are often used to guarantee income in retirement, similar to a pension.
Annuities and traditional savings accounts are both considered low-risk investment options that earn interest. However, there are many differences, including fees, liquidity and the minimum amount of money required to open an account.
Annuities and retirement accounts — such as 401(k) plans and Individual Retirement Accounts (IRAs) —feature tax-advantaged ways to save for retirement. However, IRAs and 401(k) place your money in investments, while annuities are insurance products that grow money in various ways.
Annuities also generally have higher fees than retirement accounts, but without the same annual contribution limits.
A key advantage of annuities is the ability to save money for your future without paying taxes on the interest until later.
Unlike retirement accounts, there’s no limit on annuity contributions.
One of the most attractive features of annuities is creating a guaranteed stream of income. Many people worry about outliving their savings in retirement, and annuities help hedge against this risk.
Annuities can be complex. They may not grow your money as quickly as other options, such as investing directly into the stock market.
Annuities also lack liquidity, which means it’s difficult to quickly access additional money without incurring high fees.
If your financial priorities change, you can sell your future annuity payments back to the insurance company at a discounted rate in exchange for cash. You can sell your entire annuity or just part of it.
If you sell future payments, you will receive less money than if you had continued the original payment schedule specified in your contract.
Buying an Annuity FAQs
There are three main types of annuities: Fixed, fixed indexed and variable.
Fixed annuities are tied to a guaranteed interest rate and are the lowest risk option. They offer fixed, predictable payouts.
Variable annuities carry greater risk because account growth is tied to an investment portfolio. Payout size can vary based on the market.
Indexed annuities feature characteristics of both fixed and variable. Growth is linked to a portion of a market index return, such as that of the S&P 500. This makes index annuities less risky than variable annuities while offering greater earning potential than fixed annuities.
If you want to set aside additional money for retirement, an annuity's tax-free growth can be beneficial. If you’ve already maxed out other retirement savings vehicles, such as a 401(k) or IRA, annuities may be even more appealing.
You may also consider purchasing an annuity if your market risk tolerance is low. An annuity is considered a low-risk financial product that can guarantee lifetime periodic payments.
If this appeals to you, you may want to consider purchasing an annuity.
The terms immediate and deferred indicate when payouts from the insurance company begin.
Payouts from immediate annuities start less than a year after purchase.
Deferred annuities payouts, on the other hand, begin in the future, such as at the beginning of retirement.
Annuity Payouts and Costs FAQs
Yes, but it may be expensive to do so.
If you withdraw money from an annuity before the age of 59.5, you will face a 10 percent tax penalty from the Internal Revenue Service.
You may also face a surrender charge if you withdraw money from your account early in your contract.
Yes, but how they are taxed and how much you’ll owe can vary.
For example, qualified annuities use pre-tax dollars and are often funded using a 401(k) or IRA. Because this money hasn’t been taxed yet, payouts from this annuity type are fully taxable as income.
However, annuities purchased with a Roth IRA or Roth 401(k) usually enjoy tax-free payouts.
Annuities funded with after-tax dollars are considered nonqualified. Money you originally contributed to the account is not taxed, but any earnings or interest is taxed at your regular income rate.
Withdrawing money early in your annuity contract can result in surrender charges.
Many insurers levy this fee if you take money from your account within the first five to seven years. The average surrender charge is around 7 percent but may be as high as 20 percent.
Surrender charges tend to decrease each year. So, taking money from your annuity after a year will have a higher surrender fee than taking money out after five years.
Some annuities let you withdraw up to 10 percent a year from your account without paying a surrender fee.
Possibly. Fixed annuities guarantee the safety of your principal, or the money given to the insurer to fund your annuity.
Fixed indexed annuities offer premium protection that safeguards your initial investment when the market is down.
According to the U.S. Securities and Exchange Commission, it’s possible to lose money in a variable annuity, including potential loss of your original investment, or principal.
That’s because the value of a variable annuity and its returns are linked to investment options you select. If those investments do poorly, you can lose money.
You select how much money to place in your annuity. Depending on the type of annuity you choose, this can be as little as $10,000 or as much as $1 million or more.
However, the cost of annuity fees and commissions can vary. Typically, more complex financial products come with higher fees.
For example, fixed annuities have lower costs than variable or indexed annuities. That’s because fixed annuities pay at a predictable rate and aren’t tied to investment portfolios or market indexes.
Inherited Annuity and Beneficiary FAQs
It depends on how you structured your annuity contract with the insurance company.
With some annuities, payments end when you die.
But if the annuity contract has a death benefit provision, the insurer will continue making payments to your spouse or other designated beneficiary.
If your annuity contract includes a death benefit, your selected beneficiary will either receive all the remaining funds or a guaranteed minimum amount.
There are a few different ways nonspousal beneficiaries can receive the money after you pass away. This includes taking a one-time lump sum, stretching payments over the beneficiary's lifetime or taking payments over five years.
Spouses may also have the option to continue the original contract as the annuity’s new owner.
You will owe income tax on the difference between the principal paid into the annuity and the value of the account when the owner dies. Taxes are not owed until money is withdrawn from the account.
Beneficiaries can lessen their tax burden by spreading payments over a longer period. Taking a lump sum comes with the highest tax consequences.
10 Cited Research Articles
- Lake, R. (2019, November 14). How Much Does an Annuity Cost? Retrieved from https://finance.yahoo.com/news/much-does-annuity-cost-181102718.html
- U.S. Securities and Exchange Commission. (2018, October 30). Updated Investor Bulletin: Variable Annuities. Retrieved from https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_variableannuities
- CNN Money. (n.d.). Are there tax benefits with annuities? Retrieved from https://money.cnn.com/retirement/guide/annuities_basics.moneymag/index3.htm?iid=EL
- CNN Money. (n.d.). What are the advantages of annuities? Retrieved from https://money.cnn.com/retirement/guide/annuities_basics.moneymag/index4.htm
- CNN Money. (n.d.). What if I decide to withdraw the money? Retrieved from https://money.cnn.com/retirement/guide/annuities_basics.moneymag/index9.htm
- Financial Industry Regulatory Authority (FINRA). (n.d.). Annuities. Retrieved from https://www.finra.org/investors/learn-to-invest/types-investments/annuities
- Financial Industry Regulatory Authority. (n.d.). Selecting Retirement Payout Methods. Retrieved from https://www.finra.org/investors/learn-to-invest/types-investments/retirement/managing-retirement-income/selecting-retirement-payout-methods
- Insurance Information Institute. (n.d.). What are the different types of annuities? Retrieved from https://www.iii.org/article/what-are-different-types-annuities
- U.S. Securities and Exchange Commission. (n.d.). Annuities. Retrieved from https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities
- U.S. Securities and Exchange Commission. (n.d.). Variable Annuities: What You Should Know. Retrieved from https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-5