Buying an annuity often seems like a great deal. Annuities promise to provide a stream of income that lasts for your entire life, the option of deferring taxes, and other helpful features.
But like any other choice you make with your money, annuities have both pros and cons. Knowing what they are can help you make an informed choice about whether an annuity fits your life and plans.
A bit of study can help you end up with exactly what you need—and avoid getting tangled up in the wrong product.
- An annuity is an insurance contract that can pay you regular income, either starting right away or in the future, or grow your savings over time.
- You can invest money in an annuity and choose whether it will pay you monthly, quarterly, or yearly, potentially for the rest of your life.
- Annuities charge extra fees for adding riders or investments, and those fees can add up.
- Taking money out of an annuity contract may result in taxes, penalties, and other complications on your tax return.
What Are the Basics of An Annuity?
An annuity is an insurance contract. Using an annuity often looks and feels like using an account that you put money into. How you use this account depends on the type of annuity you buy. You may invest a lump sum or add money every month. Your insurer might promise to pay you monthly income, either starting right away or waiting for a future date. Or, your savings may grow over time.
Buying an annuity can tie your money up, maybe for the rest of your life. Be sure you know what you’re getting into—and how much it will cost to get out—before you buy an annuity.
Pros of Annuities
Every annuity contract is unique. The benefits you get from yours depend on which insurance company you buy it from. They will also vary with the features you select and how you decide to use them.
Often, the most appealing feature of an annuity is the promise of income payments for life. To get this income, you invest money in an annuity. Then, you choose whether the insurer will pay you monthly, quarterly, or annually.
No matter how long you live, those payments should keep coming if you choose lifetime payments. When you retire, the payments can help replace the income you earned while you were working. Monthly payments may feel similar to monthly wages in your working years.
If you die shortly after the payments start, the insurer might be able to keep all of your money. If that concerns you, explore options such as joint lifetime payments. You may also be able to choose a beneficiary who will get payments in your place.
For example, a “10-year period certain” option keeps making payments for the greater of 10 years or the rest of your life. There are also other options you can pick from, which vary among plans.
To get the biggest monthly payments, you need to take some risk. When you choose a single lifetime income payout, with no payments to beneficiaries, you will likely be able to get the highest monthly payment. If you add a period certain or joint annuitant, the insurer will often reduce the payment, because you’re taking less risk.
Any growth, income, or interest inside of an annuity contract is often tax-deferred. In other words, you may not need to report that income to the IRS each year. Instead, you pay taxes when you withdraw funds.
That feature is often a selling point for these contracts, but it may not be as helpful as you think. If your money is already in a tax-deferred account, you don’t get any extra benefit from the tax deferral in an annuity.
Other types of tax-deferred accounts that you may have include an IRA, 401(k), or 403(b) plan.
If you happen to be in a top income tax bracket, you might be able to benefit from using an annuity. In order to be sure, run the numbers to compare the pros and of using different types of savings accounts.
For example, you still might come out ahead by using taxable accounts, depending on what type of gains you expect to receive. This will also depend on the other items on your tax return. Taking funds out of an annuity can also lead to income taxes and other penalty taxes.
If you aren't sure what type of accounts are the best place to put your money, talk to a financial advisor. They will be able to help you compare numbers and make a long-term plan.
Annuities may be able to guarantee a return on your investment. For example, fixed annuities have a stated interest rate. The insurance company pays you that amount every year. The amount may change over time, or you may receive a set rate for several years.
Some annuities also promise “hypothetical” growth. In those cases, your account balance doesn’t always grow. Instead, a hypothetical account balance increases. You can take income from this balance later in life.
Even if your actual account balance drops (or goes to zero), you may still be able to draw income.
With those contracts, the guarantee is most helpful if you keep your money with the insurance company for the rest of your life. This means that you need to be certain you’re in it for the long term before buying in.
If you decide to walk away, you might not be able to cash out the hypothetical account. Your actual account value, which may be less than the hypothetical income base, is what you can take with you.
Any annuity guarantees are only as strong as the insurance company making them. If the insurance company goes through financial problems, your savings, earnings, or income could be at risk. Choose only the strongest insurance companies, and avoid putting all your eggs in one basket.
Limited (or No) Losses
Annuities like equity-index annuities may promise that you can’t lose money in the stock market. They promise to provide some exposure to market increases with limited downside risk.
Some may even state they have no risk of loss. If that sounds too good to be true, you’ll want to find out what the tradeoffs are.
For a conservative investor, these products could make sense. But there are other options for conservative investors that are less complex. They also do not tie up your money with steep charges if you want to close the account early.
Be sure to explore all of your options before you commit to anything.
Cons of Annuities
Annuities offer appealing benefits. But, like any other investment, they come with downsides.
The base plan offered for an annuity may seem affordable. But making it work for you and your needs can be costly.
Any sort of rider or change to the base plan will change the price. When you add up the cost of contract charges, riders, and investments inside of an annuity, the all-in charges can be quite high.
Before you invest, be sure that the price you are paying makes sense for everything you’re buying.
Investing in an annuity may require a long-term commitment. If you want to cash out because you have changed your mind or need money, it could cost you.
Annuities often offset the commissions they pay to sales agents with surrender charges. These are fees you pay to withdraw money during the early years of your contract. Those charges may last 10 years or more, and a lot can happen in that time.
You can often withdraw 10% of your initial premium each year. Taking money out for certain healthcare expenses or required minimum distributions might be allowed without additional fees.
If you want to access your money early for any other reason, you may lose a lot of it to surrender charges.
Taking money out of an annuity contract may result in taxes, penalties, and other complications on your tax return. Plus, annuity withdrawals are often treated as ordinary income.
This may be taxed at a higher rate than other types of savings or investments. If you could get long-term capital gains treatment on your investments instead, that could save you a lot of money.
Review any annuity plan with a CPA who knows your tax return before you invest in an annuity.
Most insurance agents are ethical professionals who want the best for their clients. But annuities, in particular, can create ground for abuse.
Annuities pay high commissions to agents who sell them, and those agents do not always need a securities license or strong oversight to sell their products.
The fees and commissions baked into an annuity are often invisible. Agents might not tell you how much they’re earning or what tradeoffs you face when buying a high-commission product.
You may be able to offset some of the risks of buying an annuity. Immediate lifetime income annuities are simpler, and they often come with lower commission rates, Fee-only annuities do not pay the high commissions that traditional annuities feature.
Annuity Terms to Know
Learning about annuities can feel like learning a new language. If you get to know the concepts below, you will be able to make a smart choice when you research which insurance companies and annuities are right for you.
- Contract owner: If you buy an annuity, you are the contract owner.
- Premium: A monthly payment you make to keep an insurance plan.
- Surrender period: The time in which you will have to pay a surrender charge if you sell or cash out your annuity.
- Annuitant: The person who will get the income benefits of an annuity, often but not always the same person as the contract owner.
- Beneficiary: The person who gets the death benefits after the annuitant dies.
- Annuitize: Setting up a stream of regular income payments from an annuity.
- Variable annuity: An annuity with a value that changes based on how its investment accounts perform.
- Equity-indexed annuity: A fixed annuity with a rate of interest that is linked to an index, such as the S&P 500.
- Longevity annuity: Annuity that provides an income starting at a fixed date in the future, often designed to be used in old age to avoid running out of money.
- Immediate annuity: An annuity where a lump-sum contribution is used to create an ongoing stream of income for a chosen period of time.
- Deferred annuity: An annuity contract that provides income after you retire.
- Lifetime payment options: The choice to receive payments for as long as you live, which will stop after your death rather than returning money to your heirs.