Annuities are potential income sources during retirement, available in fixed, variable, or indexed types with varying levels of risk. Prior to purchase, information about fees, surrender charges, and withdrawal penalties should be evaluated as these can affect returns or accessibility. We have compiled a guide on the primary types of annuities and some tips for choosing the right one for your retirement plans.
Annuities equate to a contract between the holder and an insurance company. In exchange for contributions, the insurer guarantees a set amount of money at the agreed periods for a specified duration. Often recognized as retirement-income insurance, annuities assure regular income flow after retirement - typically for life.
Annuities also come with tax advantages. Investment earnings are tax-free until withdrawal, offering an appealing feature to retirement savers. Acquisition of a deferred annuity allows for tax-free, compounded investment with future guaranteed cash flows.
However, note that annuities may penalize for early withdrawal. Tax regulations encourage postponement of withdrawals until a minimum age of 59 1/2, with a 10% penalty for early withdrawal enforced by the IRS. Although, exceptions allow for penalty-free withdrawals under qualifying reasons, and some contracts permit annual 10%-15% withdrawals for any purpose.
Annuities are broadly categorized into immediate and deferred types. Immediate annuities involve a lump sum payment to the insurer for immediate return payments. These payments could be either fixed or variable, per contract terms. Immediate annuities are suitable for those with a one-time financial influx, such as an inheritance or those nearing retirement looking to supplement their income.
Deferred annuities are structured for capital accumulation over your working life, which can then be converted into income for later years. The contributions made grow tax-deferred until the account begins to pay income, referred to as the accumulation phase.
There are several subtypes within these categories, such as fixed, indexed, and variable annuities. Fixed annuities provide a secure source of predictable retirement income, offering the guarantee of a set return rate, with the risk lying with the insurance company. However, an underperforming market will benefit the insurance company, not the holder. Also, the purchasing power of a low-yielding fixed annuity can decrease in times of inflation.
Indexed annuities combine features of fixed annuities with the potential for additional investment growth based on market performance. You’re guaranteed a minimum return, plus a return linked to the rise in the relevant market index.
In contrast to indexed annuities, variable annuities provide a return based on the performance of the selected mutual fund portfolio.
Consideration must be given to the life expectancy of the annuitant as it significantly impacts the value received from the annuity contract. Also, the annuity contract may include several other provisions, such as a guaranteed number of payment years.
Annuities provide several tax benefits during the accumulation phase of an annuity contract, your earnings grow tax-deferred. Consultation with a financial advisor is beneficial to decide if an annuity or another investment is best suited to provide financial needs during retirement.