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Retirement income can come from a number of financial sources; some guaranteed, some not. Annuities are an option for people who want to bulk up the guaranteed income portion of their retirement portfolio.
Generally, an annuity works like this: You purchase the annuity, either in a lump sum or a series of payments. In return, the annuity will make payments to you at a future date or series of dates.
Annuities come in many different “flavors” – each of which is designed to help you achieve specific financial goals. They can work to build retirement savings, supplement other forms of retirement funding, or both. (Related: Retirement income calculator)
The different varieties of annuities can also be bewildering. Depending on individual circumstances, many people turn to a financial professional to help them navigate the choices.
Traditional deferred annuities
“Traditional” deferred annuities are the kinds of annuities with which most people are familiar. They are designed to help you accumulate assets on a tax-deferred basis as you save for long-term goals like retirement. Let’s look at two basic examples of traditional deferred annuities: “fixed” and “variable”.
Deferred fixed annuities are “fixed” because they offer fixed interest rates. They are “deferred” because they require a waiting period before annuity payments can begin. During the deferral period, money in your contract is credited with a fixed rate of interest and grows at a steady pace.
Because you don’t pay current income taxes on the earnings in your contract until you withdraw it, more of your money remains available to benefit from that steady growth. Fixed deferred annuities also offer annuity income options that can provide guaranteed income for life or a certain period of time (like 10 or 20 years). This type of annuity typically includes a withdrawal provision that allows you to access the money in your contract. It’s important to understand, however, that withdrawals may be subject to surrender charges, income tax, and even tax penalties.
A fixed deferred annuity may be worth considering if you are looking for a conservative way to grow a portion of your assets and avoid market volatility. It may not be the best choice if you prefer greater growth potential (and don’t mind taking on the risk that goes with it) or if you need income that starts right away. (Related: 5 reasons why you may need an annuity)
Variable deferred annuities – Unlike fixed annuities, variable annuities are built to provide financial market exposure. Variable annuities generally offer a broad range of investment options – from more conservative fixed accounts to riskier growth options.
Like a fixed deferred annuity, the money in a variable annuity also benefits from tax deferral. You don’t pay current taxes on earnings in your contract until you withdraw them – which means more of your money remains available to benefit from potential growth. A variable annuity also offers a variety of options when it comes to receiving income – including lifetime income options. (Related: Understanding annuitization)
Of course, greater growth potential involves more risk. A variable annuity can increase or decrease in value, depending on how financial markets perform. When considering a variable annuity, it’s essential to understand how the annuity works, including associated fees and expenses as well as the surrender charges, income tax and tax penalties that typically apply to deferred annuities. Just as important, you should have a clear sense of your financial goals and tolerance for risk. A financial professional can help you make an informed decision on whether a variable annuity is right for you.
Income Annuities
There are types of annuities that are expressly designed to provide a guaranteed income stream in retirement – income annuities. And although income annuities share some similarities with their traditional counterparts, they differ in important ways.
Income annuities are designed for the sole purpose of providing a guaranteed stream of income, either immediately or in the future. (Related: When is the right time to buy an annuity?)
An immediate income annuity typically is purchased with a single premium or “purchase payment” and requires that income payments begin within 12 months of the date your contract is issued. Income can be guaranteed for as long as you live or for a specific period of time. Because immediate income annuities guarantee a specific income amount, they offer very limited access to withdrawals, and only for some annuity options. Even if you choose an annuity option that allows withdrawals, it’s important to remember that withdrawing money from your contract can have a significant impact on the dollar value of future annuity payments.
An immediate income annuity may be worth considering if:
- You are nearing or already in retirement.
- Want the security of guaranteed, predictable income.
- Need that income to start right away or very soon.
If you think you might need that money down the road and you have limited additional liquid assets, an immediate income annuity is probably not the best choice for you.
A deferred income annuity, on the other hand, is designed to provide guaranteed future income. A deferred income annuity generally permits multiple “purchase payments” over a period of time. On the annuity date you choose, all purchase payments are combined into a single, guaranteed income stream that will continue for as long as you live; some deferred income annuities offer period certain options as well. In this sense, a deferred income annuity can be used to generate a “pension-like” stream of future guaranteed income.
A deferred income annuity differs from a traditional deferred annuity in important ways. In general, a deferred income annuity:
- Does not provide liquidity; there is no contract value or ability to make cash withdrawals, as there is with a traditional deferred annuity. The only time that distributions are made from a deferred income annuity contract is when annuity payments are made or a death benefit is paid.
- Because there is no contract value or liquidity, and your guaranteed income is paid to you over your lifetime, longer-duration, higher- yielding assets can be used to support that guaranteed income. That’s why a deferred income annuity can guarantee a higher future income amount than a traditional deferred annuity at the time you make your purchase payment(s).
If you are considering a deferred income annuity, it’s essential to have a separate source of liquid assets set aside for emergencies. It’s also important to get the facts and speak with a financial professional.
So which annuity should you consider?
That depends on many factors.
For retirement purposes, an annuity can work in conjunction with the savings in your 401(k) plans or IRAs (both of which can be affected by market ups and downs). And given the way life spans are stretching, there’s also a chance you may outlive your savings.
In that regard, there is a type of annuity ― called a qualified longevity annuity contract ― that can be bought with money from qualified retirement accounts. (Related: Understanding the QLAC)
An annuity can also work to supplement other sources of retirement income that are guaranteed, like a defined benefit pension plan or Social Security.
With any annuity, it’s important to get the facts before making your decision. Retirement is your reward for decades of hard work—and part of that work is making sure you’ll have enough money for the kind of retirement you want. If you are looking for an additional source of predictable income now or in the future or a product that is designed to help you accumulate assets on a tax-deferred basis, annuities may be an option worth exploring.
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This article was originally published in June 2016. It has been updated.
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