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You may already take advantage of a financial product such as a 401(k) or an individual retirement account (IRA) to put away money for retirement. Another investment option for retirement is something known as an annuity. An annuity is an insurance contract that pays money to you either now or sometime in the future.
But is an annuity a good retirement investment? Here, we review the pros and cons of putting your money into an annuity.
What Is an Annuity?
People typically buy annuities to provide a source of income during retirement. Annuity payments can be made to the issuer in one lump sum or over a certain period of time. Likewise, payments from an annuity can be made in one lump sum or over a certain period of time.
Annuities are sold by insurance companies, banks, brokerage firms and mutual fund companies. They fall into three buckets.
1. Fixed Annuity
A deferred fixed annuity earns interest at a rate established by the insurer; the rate can fluctuate over time, but there's normally a guaranteed minimum rate. With another type of fixed annuity, a deferred fixed index annuity, the interest rate is tied to a market index like the S&P 500. The deferred fixed index annuity holds the potential for a higher interest rate than a deferred fixed annuity, but it also carries more risk and the possibility of zero interest.
2. Variable Annuity
The value of a variable annuity goes up or down based on the value of the underlying investments. When you buy a variable annuity, you select from among investments called "subaccounts." These include stocks, bonds and money market accounts.
3. Income Annuity
An income annuity offers guaranteed income rather than providing a way to save for retirement. Through this annuity, you make one lump-sum contribution that turns into a steady stream of income. The income can be immediate (sometimes as soon as one month after you buy the annuity) or deferred (with payouts delayed until a future date).
Pros and Cons of Annuities
Pros and cons accompany any investment product for retirement, and annuities are no exception.
Here are five of the pros of annuities.
- An annuity may lend a sense of financial security, particularly for those who are near retirement and are nervous about volatility in the stock market.
- Interest earned on an annuity can grow on a tax-deferred basis.
- As opposed to a 401(k) or an IRA, an annuity usually comes with no annual contribution limits.
- Unlike traditional retirement accounts, you're not required to start withdrawing money from an annuity at age 70½.
- Generally, your designated beneficiaries can get payouts from your annuity after you die even if you haven't withdrawn any money.
Here are five of the cons of annuities.
- The issuer of an annuity may charge various fees, such as a flat annual fee or a percentage fee to cover administrative expenses.
- Some annuity fees are higher than fees for other retirement options.
- If you withdraw money from an annuity before age 59½, the IRS may impose a 10% penalty. That would come on top of any federal taxes you might owe on the money that's withdrawn.
- Unlike money in savings accounts, annuities are not federally insured. Therefore, if the insurer that issued your annuity goes out of business, neither the Federal Deposit Insurance Corp. (FDIC) nor the National Credit Union Administration (NCUA) can come to your rescue. Also, annuities also often lack the consumer protections provided by the Securities Investor Protection Corp. (SIPC). SIPC helps protect investors' assets when a brokerage firm fails.
- If you need to tap into an annuity to cover big expenses, such as an unexpected hospital bill, you may not be able to withdraw the money as quickly as you'd like. Plus, you may face penalties for early cash withdrawal.
How Do Annuities Compare to Other Retirement Options?
Annuities are just one option to prepare for retirement. Here are three other options.
An employer-sponsored 401(k) retirement account enables you to put aside money for retirement through investment products such as stocks, bonds, mutual funds and exchange-traded funds (ETFs). It's a common way for people to save money for retirement over the long term.
One advantage of a 401(k) versus an annuity is that employers often contribute matching funds to your 401(k); employers don't contribute to annuities. One disadvantage, however, is that annual contributions to a 401(k) are capped, whereas annual contributions to an annuity typically are not capped.
Like a 401(k), an IRA lets you save for retirement by purchasing stocks, bonds, mutual funds, ETFs and other investment products. Withdrawals from a traditional IRA are taxed, while withdrawals from a Roth IRA are tax-free. One benefit of an IRA versus an annuity is that it offers flexibility in deciding where to invest. One drawback, though, is that an IRA doesn't provide a steady stream of income the way an annuity does.
Both annuities and the federal government's Social Security program offer a regular source of income during retirement. One advantage of Social Security is that it automatically includes cost-of-living adjustments; the buyer of an annuity must pay a higher amount to qualify for cost-of-living adjustments. One obvious drawback is the concern over long-term Social Security solvency.
Does It Make Sense to Add an Annuity to Your Retirement Portfolio?
An annuity may make sense if you continually max out your annual contributions to a 401(k), IRA or other retirement account, as an annuity can give you another avenue for retirement savings. It also may be a good move if you're approaching retirement and seeking another source of steady income.
Because there are different types of annuities that invest and pay out your funds in various ways, make sure you understand what you're getting into before you purchase an annuity. In addition, don't forget that an annuity may charge fees that wind up being higher than those for a 401(k) or another retirement product.
When Might an Annuity Be Right for You?
An annuity can enable you to build tax-deferred retirement savings and generate long-term income. However, you must weigh those benefits against the downsides. Those include any fees attached to an annuity and the likelihood that your annuity doesn't enjoy the same consumer protections that savings and retirement accounts do.
Before deciding to purchase an annuity, assess your current retirement portfolio. If you already have an IRA or another retirement account that provides tax-deferred savings, then you might consider buying an annuity only if it delivers different advantages. Those advantages may include guaranteed income or guaranteed death benefits.
The Bottom Line
If you're looking at buying an annuity, take stock of your current financial situation to ensure you can afford the monetary commitment. This review of your finances should include obtaining your free Experian credit report so you can check how much debt you're carrying and help determine how much you have to invest.