When to Consider Annuities If You Want to Protect Your Pension
You probably know that saving for retirement is a big deal. If you like the idea that you can ultimately enjoy life without relying on a job, you’ll want to contribute to an IRA, take advantage of employer 401 (k) compliance, or better yet, do both. But there is another option that you may not have considered in your retirement plan: annuities. Here is a short description of what they are.
How annuities work
An annuity is a kind of mixture of an insurance plan and an investment account. If you go into details, they are most reminiscent of the former and can be quite hairy. Simply put: An annuity is a financial product that guarantees income upon retirement. You pay the premium (or lump sum) now, and once you are 59 ½ years old, you will be guaranteed payment. Sounds good, right? Okay, maybe.
Apart from the basic definition, there are a few key points you should know about annuities. This will help you learn more about how they work and their pros and cons. Remember these basics:
- They have tax deferral: annuities offer a tax advantage. Specific benefit? Your income (not contributions) is tax deductible. This means that the money you earn as an annuity is tax deductible until you collect it at retirement, just like a traditional IRA or 401 (k).
- You can save more of your money: Both 401 (k) s and IRAs have limits on how much you can contribute annually in accordance with IRS guidelines. But there is no IRS annuity limit. Unfortunately, you usually cannot deduct the money you contribute to your annuity from your income, as you can with a traditional IRA or 401 (k). If you do not buy an annuity through an IRA or 401 (k), it is payable in dollars after taxes. We’ll learn later how it works.
- Retirement Income Guaranteed : Here’s the main argument for an annuity: your retirement income is more or less guaranteed. When you buy an annuity, the insurance company agrees to pay you a specified amount of money over a specified period of time. If you withdraw before retirement age (59 ½), you will be fined 10% of the taxable portion of the annuity.
- It’s a pool of money : like any insurance product, annuities are paid for by other people’s insurance premiums. When people in the pool die, the money they deposited is used to fund other annuities.
These are the basics, but there are different types of annuities with different characteristics.
Different types of annuities
Annuities are divided into different categories based on their payout, growth, and your contribution to them. The two most basic categories are deferred and immediate.
Deferred Vs. Immediate annuities
With a deferred annuity, you invest in the annuity for a specified period of time until you are ready to withdraw funds. With an immediate annuity, you make an initial lump sum investment and the annuity starts paying immediately or within a year. This is usually the type to consider if you are approaching retirement age and do not have enough savings.
Basically, a deferred annuity accumulates over time, whereas an immediate annuity is paid to you … well, immediately. According to Learnbonds , deferred annuities have a waiting period of 5 to 10 years, after which you have several options:
- Withdraw your money. This will immediately entail tax implications.
- Make a tax-free transfer to the new annuity.
- Convert a deferred annuity to an immediate one. This is called “annuity”.
The main benefit of a deferred annuity is the ability to defer taxes. Although both types of annuities are tax deferred, over time, this benefit will matter most. If you are withdrawing money now, there is no time to set aside growth taxes. Of course, if you are looking to retire, immediate annuity has obvious benefits.
Fixed, variable and indexed annuities
Annuities are further classified according to how they grow.
Fixed annuity offers a flat rate and pays out a guaranteed amount based on your account balance. The risk is low, but the income is often low. It’s kind of like a CD . In fact, the rates are only slightly higher than CDs.
If you want a higher rate of return, you may want to consider using a variable annuity . Here, your money is mostly invested in mutual funds, and your rate is higher, but so is your risk. As such, your retirement benefit will vary depending on how that investment is performing. Typically, there are more fees associated with a variable annuity as well.
Finally, there are indexed annuities that try to offer the best of both worlds. They offer a guaranteed minimum payout, but you can still benefit when an index (like the S&P 500) does well. If it sounds too good to be true, it is. CNN reports that they can be overly complex, misleading, and contain provisions that prevent you from fully benefiting from the index.
Different types of annuities offer different payouts. You may receive payments periodically for the rest of your life, you may receive a lump sum payment upon retirement, or you may receive payments periodically for a specified number of years.
Some annuities, such as life annuities, do not offer beneficiaries. This means that after you die, the money will disappear; no heirs. Others offer a guaranteed death benefit when the recipient receives a certain amount after you die. CNN lists several main types of annuity payments:
- Guaranteed income, also known as a specific annuity period, where you are guaranteed a specific amount over a specific period of time. If you die before the end of the period, your recipient will receive the remainder of the payments.
- Lifetime Payments : This offers a guaranteed payout of income only for the duration of your life. When you die, payments stop.
- Lifetime Income with Defined Period Benefit : Also known as “period life,” it gives you a guaranteed payment for life with a specific period phase. If you die during this phase, your beneficiary will receive the remainder of the payments for this period.
- Annuity joint and survivor annuity : This is usually an option for married couples that gives your recipient a steady payment for the rest of his or her life.
Therefore, if you are considering an annuity, you will need to decide when you want payment (immediate or deferred), how you want your money to grow (fixed, variable, or “indexed”) and what options you want. upon payment. Of course, the better an annuity looks, the more it costs.
Why people like annuities
There are two main benefits of annuities. First, they are tempting for people trying to catch up with retirement. When you are low on savings and worried about how you will get along, an annuity can offer predictable income. But counting on an annuity for your entire retirement plan is still not a good idea. You should never put all your eggs in one basket. (Especially when that basket is expensive, but we’ll talk about fees a little later.)
It is also unreasonable to view an annuity as an investment: it is an insurance product. While you can make a profit from them, they are mainly meant to back up you rather than help you grow your nest egg. Considering annuity fees, there are more cost effective ways to invest your money.
People also love the tax breaks that annuities offer. If you have exhausted your 401 (k) and your IRA, congratulations first. Secondly, you may be looking for another way to multiply your money. A taxable investment account is an option, but there is no tax benefit like there is with an annuity. Again, you will eventually have to pay taxes on this income, but only after you collect the money.
Why people don’t like annuities
Most annuities come with crazy fees, which makes them less than ideal investment options. In fact, they are rather notorious for their spending. Here are some of the costs you will find on an annuity:
- Commissions : Forbes writer (and former annuity seller) Tim Maurer reports that some annuity commissions can be as high as 15% . CNN rates around 10% . As you can imagine, the commission is included in the cost of the annuity.
- Surrender Fees: If you withdraw money from your annuity within the first few years after purchase, you will be required to pay a change charge. The Motley Fool says a 7% first year change fee is pretty typical. This is 7% of the value of your bill. Annuity companies usually reduce this amount by 1% each year to zero.
- Annual Fees : Variable annuities usually have higher annual costs. CNN cites a figure of 1.25% or more for the annual insurance fee, followed by another 0.5-2% for the management fee.
Moreover, many do not offer high enough profit margins. Maurer reports on CNBC that rates could be so low that they risk outstripping inflation. Therefore, if you are thinking of an annuity, he suggests waiting for rates to normalize. But again, this is an insurance product, not an investment.
Finally, even though they are tax deferred, annuity taxes can be quite high. Capital gains, the income you receive from the sale of their investments, typically taxed at a lower rate than your tax bracket. This is not the case for capital gains annuity. They are taxed as ordinary income. Tax rules can be confusing, but Motley Fool describes them in more detail here . The point is, the benefit of tax deferral looks less appealing when you actually start withdrawing money.
If you have an annuity?
Most experts do not recommend considering annuities unless you are approaching retirement age, playing catch-up, and needing some sort of guaranteed income.
You will definitely want to make sure that you have exhausted your 401 (k) and IRA as much as possible before even considering an annuity. They offer the same tax deferral, only without the high fees. And if you invest in an annuity through your 401 (k) or other tax-exempt account, you don’t get any additional tax breaks anyway, because the money is already coming from the reduced account.
If you are all in favor of an annuity, there are several ways to invest in one. Some 401 (k) or IRA plans offer the option to invest in an annuity, but US News points out that you probably won’t be able to invest that money in a new 401 (k) plan if you change employers.
However, you can convert your existing 401 (k) into an annuity if you change jobs. They report:
Leaving an employer for any reason – a new job, layoffs, being laid off, or simply being laid off – is a layoff, so you can shift some of your financial balance to annual income under any of these circumstances. In addition, after retirement, you can transfer part of your balance to the annuity; If your plan includes this option, it may also offer discounts.
Of course, you can always buy on your own outside of your employer’s 401 (k) plan. Investment firms such as Fidelity and Vanguard offer different types of annuities, as do some insurance companies.
Be sure to research the fees, company credit rating, and all the other details mentioned in this post, from transfer fees to payout options. Annuities aren’t for everyone, but if you’re worried about your retirement income, they are worth considering. Like everything else, you’ll want to read the fine print, scrutinize your options carefully, and know what you’re getting yourself into.