You may have heard that IRAs and employer-sponsored plans (e.g., 401(k)s) are the best ways to invest for retirement. That's true for many people, but what if you've maxed out your contributions to those accounts and want to save more? An annuity may be a good investment to look into.
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An annuity is a tax-deferred insurance contract. The details on how it works vary, but here's the general idea. You invest your money (either a lump sum or a series of contributions) with a life insurance company Financial Advisory Abney Associates that sells annuities (the annuity issuer). The period when you are funding the annuity is known as the accumulation phase. In exchange for your investment, the annuity issuer promises to make payments to you or a named beneficiary at some point in the future. The period when you are receiving payments from the annuity is known as the distribution phase. Chances are, you'll start receiving payments after you retire. Annuities may be subject to certain charges and expenses, including mortality charges, surrender charges, administrative fees, and other charges.
Understanding your annuity payout options is very important. Keep in mind that payments are based on the claims-paying ability of the issuer. You want to be sure that the payments you receive will meet your income needs during retirement. Here are some of the most common payout options:
You receive payments from the annuity over a specific number of years, typically between 5 and 20. If you die before this "period certain" is up, your beneficiary will receive the remaining payments.
You combine a lifetime annuity with a period certain annuity. This means that you receive payments for the longer of your lifetime or the time period chosen. Again, if you die before the period certain is up, your beneficiary will receive the remaining payments.
Your investment earnings are tax deferred as long as they remain in the annuity. You don't pay income tax on those earnings until they are paid out to you.
If you die with an annuity, the annuity's death benefit will pass to your beneficiary without having to go through probate.
You don't have to meet income tests or other criteria to invest in an annuity.
You're not required to start taking distributions from an annuity at age 70½ (the required minimum distribution age for IRAs and employer-sponsored plans). You can typically postpone payments until you need the income.
But annuities aren't for everyone. Here are some potential drawbacks:
Once you've elected to annuitize payments, you usually can't change them, but there are some exceptions.
You may have to pay other costs when you invest in an annuity (e.g., annual fees, investment management fees, insurance expenses).
Investment gains are taxed atss ordinary income tax rates, not at the lower capital gains rate.
If you think that an annuity is right for you, your next step is to decide which type of annuity. Overwhelmed by all of the annuity products on the market today? Don't be. In fact, most annuities fit into a small handful of categories. Your choices basically revolve around two key questions.
First, how soon would you like annuity payments to begin? That probably depends on how close you are to retiring. If you're near retirement or already retired, an immediate annuity may be your best bet. These types of annuity starts making payments to you shortly after you buy the annuity, typically within a year or less. But what if you're younger and retirement is still a long-term goal? Then you're probably better off with a deferred annuity. As the name suggests, this type of annuity lets you postpone payments until a later time, even if that's many years down the road.
Second, how would you like your money invested? With a fixed annuity, the annuity issuer determines an interest rate to credit to your investment account. An immediate fixed annuity guarantees a particular rate, and your payment amount never varies. A deferred fixed annuity guarantees your rate for a certain number of years; your rate then fluctuates from year to year as market interest rates change. A variable annuity, whether immediate or deferred, gives you more control and the chance to earn a better rate of return (although with a greater potential for gain comes a greater potential for loss of principal). You select your own investments from the subaccounts that the annuity issuer offers. Your payment amount will vary based on how your investments perform.
Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders.
It pays to shop around for the right annuity. In fact, doing a little homework could save you hundreds of dollars a year or more. Why? Rates of return and costs can vary widely between different annuities. You'll also want to shop around for a reputable, financially sound annuity issuer. There are firms that make a business of rating insurance companies based on their financial strength, investment performance, and other factors. Consider checking out these ratings.