You probably know saving for retirement is a big deal.
But theres another option you may not havent considered in your retirement plan: annuities.
Heres a primer on what theyre all about.
When you get into the details, they mostly resemble the former, and they can be pretty hairy.
Simply put: an annuity is a financial product that guarantees income in retirement.
Sounds like a good deal, right?
Aside from the basic definition, there are a few key points you should know about annuities.
This will help you understand more about how they work and their pros and cons.
Keep these basics in mind:
Theyre tax-deferred:Annuities offer a tax advantage.
Your earnings (not contributions) are tax-deferred.
But theres no IRS cap on an annuity.
Unless youre buying the annuitythroughyour IRA or 401(k), its paid with post-tax dollars.
Well get to how that works later.
Its a pool of money: Like any insurance product, annuities are paid for with other peoples premiums.
When people in the pool pass away, the money theyve contributed is used to fund other annuities.
Those are the basics, but there are various types of annuities with different characteristics.
The two most basic categories are deferred and immediate.
Deferred Vs.
This will generate an immediate tax consequence.
Make a tax-free transfer into a new annuity.
Turn your deferred annuity into an immediate annuity.
This is called annuitization.
The main draw of a deferred annuity is the ability to defer taxes.
While both types of annuities are tax-deferred, that benefit is going to make the most difference with time.
If youre withdrawing the money now, theres no time to defer taxes on growth.
Of course, if youre about to retire, the immediate annuity has obvious benefits.
Fixed, Variable, and Indexed Annuities
Annuities are further categorized by how they grow.
Afixed annuityoffers a set rate and pays a guaranteed amount based on your account balance.
Its low risk, but the return is often low, too.
Itssort of like a CD.
In fact, rates are only slightly higher than what youd get with a CD,.
If you want a higher return, you might consider avariable annuity.
Thus, your retirement payout will vary depending on how those investments perform.
There are usually more fees associated with variable annuities as well.
Lastly, there areindexed annuities, which have a go at offer the best of both worlds.
Payout Options
Different kinds of annuities offer different payouts.
Some annuities, like Lifetime Annuities, dont offer beneficiaries.
Meaning, after you die, the money is gone; there are no heirs.
If you die before the period ends, your beneficiary gets the remainder of the payments.
Lifetime payments: This offers a guaranteed income payout only during your lifetime.
When you die, payments stop.
If you die during this phase, your beneficiary will receive the rest of the periods payments.
Of course, the better the annuity looks, the more it costs.
Why People Like Annuities
There are two main draws to annuities.
First, theyre tempting for people who are trying to play catch up with their retirement.
But its still not a good idea to rely on an annuity for your entire retirement plan.
Its never a good idea to put all of your eggs in one basket.
(Especially when that basket is a costly onebut well get to the fees in a bit.)
Its also not smart to consider an annuity an investment: its an insurance product.
Considering the fees with an annuity, there are more cost effective ways to invest your money.
People also like the tax advantages that annuities offer.
If youve maxed out your 401(k) and your IRA, first of all, congratulations.
Second, you might be looking for another vehicle to grow your money.
A taxable investment account is an option, but theres no tax advantage like there is with an annuity.
Again, youll eventually have to pay taxes on those earnings, but not until you withdraw the money.
In fact, theyre pretty notorious for their expense.
CNNestimates about 10%.
The Motley Foolsays that a surrender charge of 7%in the first year is pretty typical.
Thats 7% of your account value.
Annuity companies usually reduce that amount by 1% for every year until zero.
Annual fees: Variable annuities usually have higher annual expenses.
So if youre thinking about an annuity, he suggests waiting until rates normalize.
But again, its an insurance product, not an investment.
This isnt so for an annuitys capital gains.
Theyre taxed as normal income.
The tax rules can be confusing, but the Motley Fooloutlines them in more detail here.
The point is, the tax-deferral advantage looks less appealing once you actually start withdrawing the money.
Should You Have an Annuity?
They offer the same tax-deferral, just without the high fees.
If youre all for an annuity, there are a few ways to go about investing in one.
Some 401(k) or IRA plans offer the option to invest in an annuity, butU.S.
you might, however, roll your existing 401(k) into an annuity if you change jobs.
Investment firms like Fidelity and Vanguard offer different types of annuities, as do some insurance providers.
