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.
GET THE LAY OF THE LAND
An annuity is a tax-deferred investment 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 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.
UNDERSTAND YOUR PAYOUT OPTIONS
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 surrender the annuity and receive a lump-sum payment of all of the money you have accumulated.
- 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 receive payments from the annuity for your entire lifetime. You can't outlive the payments (no matter how long you live), but there will typically be no survivor payments after you die.
- 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.
- You elect a joint and survivor annuity so that payments last for the combined life of you and another person, usually your spouse. When one of you dies, the survivor receives payments for the rest of his or her life.
- When you surrender the annuity for a lump sum, your tax bill on the investment earnings will be due all in one year. The other options on this list provide you with a guaranteed stream of income (subject to the claims-paying ability of the issuer). They're known as annuitization options because you've elected to spread payments over a period of years. Part of each payment is a return of your principal investment. The other part is taxable investment earnings. You typically receive payments at regular intervals throughout the year (usually monthly, but sometimes quarterly or yearly). The amount of each payment depends on the amount of your principal investment, the particular type of annuity, the length of the payout period, your age if payments for lifetime payments, and other factors.
CONSIDER THE PROS AND CONS
An annuity can often be a great addition to your retirement portfolio. Here are some reasons to consider investing in an annuity:
- 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.
- An annuity may be free from the claims of your creditors in some states.
- If you die with an annuity, the annuity's death benefit will pass to your beneficiary without having to go through probate.
- Your annuity can be a reliable source of retirement income, and you have some freedom to decide how you'll receive that income.
- You don't have to meet income tests or other criteria to invest in an annuity.
- You're not subject to an annual contribution limit, unlike IRAs and employer-sponsored plans. You can contribute as much or as little as you like in any given year.
- 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.