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Say you own an annuity and approaching or in retirement. You need money from the annuity. How do you get it?
You generally have two choices: withdrawals or annuitization. Each option comes with different rules and financial consequences. Deciding which alternative is right for you will depend on your specific needs, risk tolerance, and life expectancy.
“For many people, it will come down to a question of control … and that can be hard when money’s involved,” said Mark R. McManus, a senior vice president with Baystate Financial in Southborough, Massachusetts. “It’s especially challenging when you’re talking about perhaps a big part of your retirement savings. Do you make a large savings number become a series of smaller payments? The math may make sense, but emotions can be a struggle.”
So before making the decision, you need to understand both.
Annuity basics
An annuity is a contract where, in exchange for a payment or a series of payments, an insurance company will provide a guaranteed stream of payments to the contract owner. Those payments can come either immediately (income annuities) or sometime in the future (deferred annuities).
Some types of deferred annuities can offer a number of advantages for retirement and financial planning, including tax-deferred growth,1 protection from market volatility, and guaranteed income in retirement. But they also come with certain costs and restrictions on how the owner can access the contract value. (Learn more: The pros and cons of annuities)
“Annuities wrap around your money to give you additional benefits … that’s the easiest way to explain it,” said Victoria Thomas, a financial professional and vice president with GoldBook Financial in Scottsdale, Arizona. “They can give you guaranteed income, downside protection from the market, tax deferral, and help manage required minimum distributions. They can help you manage risk.”
Withdrawals from an annuity
Certain types of annuities can allow for withdrawals, while others typically don’t.
Those that usually don’t allow for withdrawals are those aimed at providing a guaranteed stream of income right away or at a particular point in the future. These types of annuities would include immediate income annuities (like a single-payment income annuity) and deferred income annuities.
Annuities that do allow for withdrawals are those aimed at providing some growth in value over time. These types would include variable annuities, fixed index annuities, and deferred fixed annuities.
These growth-oriented annuities are designed for long-term financial goals. So, such annuities typically come with restrictions on when and how much money can be withdrawn.
In particular, surrender charges are applied to withdrawals from these types of growth-oriented annuities within certain time periods, usually in the first seven years of the investment.2 In some cases, there can also be tax consequences and an added 10 percent penalty for accessing funds from an annuity before age 59½.
But after such time, withdrawals can become a viable option for accessing funds from the annuity.
What are the advantages?
- Flexibility, for one, since an annuitant can tap funds in their annuity as needed. And they don’t have to withdraw funds at all, if they prefer, but just let funds continue to grow in a fixed annuity or potentially grow in a variable annuity.
- Control is another. The annuitant maintains control over the principal and, depending on the type of annuity involved, how the money in the annuity is invested.
But there can also be drawbacks. Withdrawals obviously reduce the value of a growth-oriented annuity. That, in turn, can negatively affect its future income potential, particularly in comparison with annuitization.
Annuitization
Annuitization is the point at which the annuity investment is converted into a stream of guaranteed income payments. The size and length of those payments will depend on a number of factors. But it is at this time that most annuities become illiquid, meaning there is no longer contract value in which to take withdrawals in addition to the guaranteed annuity payments. (Learn more: What is annuitization and how does it work?)
What are the advantages of annuitization?
- Predictable and guaranteed income for a certain period of time or even a lifetime, depending on choices made at annuitization.
- Elimination of the risk of losing money due to market volatility.
- There are no fees for annuitization.
But there can be drawbacks as well. Annuitization means giving up access to the principal in the annuity and the ability to change the payment amount or frequency.
Comparing the two
So which method of receiving money from an annuity is better? Like most situations in the financial world, the answer is: it depends.
It’s essentially a trade-off between flexibility and control on the one hand, and security and dependability on the other.
“Sometimes, with pure annuitization, you can commit less money to achieve the result you want in retirement,” said Thomas. “But on the other hand, many people are attracted to withdrawals because they envision still having a big bag of money that they can grab later on if they need it. It’s a control question.”
As noted, once annuitization has taken place, the annuitant is committed to receiving guaranteed annuity payments. With a withdrawal strategy, an annuitant can tap funds in their annuity as needed, although, depending on the terms of the annuity contract, there may be a cost.
“As an advisor, I am always concerned about the fees associated with a guaranteed withdrawal/income benefit,” said Thomas. “In some cases, the fees may not be worth the payout and also can hinder the potential growth of the account value.”
However, a withdrawal strategy may not be sustainable for some types of annuities where withdrawals may not be guaranteed for life or a specific period of time — as they are with annuitization — and would cease upon the contract value going to zero. In such cases, over time and depending on longevity, an annuitant would likely receive more in guaranteed annuitized payments than using unscheduled withdrawals.
To be sure, some annuities offer a rider, for a fee, that allows the continuation of the same payment or some form of payment for the annuitant’s life even if the account goes to zero.
“With annuitization, it’s like you are owning your retirement income stream, but losing control of its source, which is a hurdle for some people,” said McManus. “But with a systemic withdrawal plan, such as using a variable annuity with a guaranteed lifetime withdrawal benefit, you’re renting the income with an option to own if the market does not cooperate.”
Indeed, market volatility is also a consideration when choosing between annuitization and a withdrawal strategy. Annuitization eliminates market risk, while a market downturn using a withdrawal strategy could negatively impact your income plan. (Related: Ideal retirement withdrawal rates)
There’s also inflation. Annuity payments through annuitization do not keep up with inflation and, depending on the type of annuity, a withdrawal strategy may not either. (Related: Is your retirement portfolio inflation ready?)
But also of note, depending on the contract terms, annuitization may eliminate the possibility of a death benefit for a beneficiary. With a withdrawal strategy, a beneficiary may be able to receive a death benefit, depending on the value remaining in the contract.
And there may be tax considerations. In the case of nonqualified annuities, any earnings are taxed as ordinary income. And how distributions from such an annuity are taxed can depend in part on whether distributions are made through annuitization or withdrawals.
Obviously, the most appropriate choice between annuitization and withdrawals will depend on individual circumstances. Annuitization has the benefit of guaranteed income, possibly for life. But if someone has other sources of stable retirement income, the flexibility of withdrawals might be a suitable option. (Related: Does an annuity fit your retirement goals?)
“You really want to talk to a financial professional, to compare products,” suggested Thomas. “They can help you understand the investment selections, the fees, the withdrawal benefits, and other features.”
Discover more from MassMutual …
Annuities: Criticisms and rebuttals
When is the right time to buy an annuity?
What is a QLAC? How can it help with RMD rules?
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1 Tax deferral is automatically provided by tax-qualified retirement plans, including IRAs. There is no additional tax-deferral benefit provided when an annuity contract is used to fund a tax-qualified retirement plan or an IRA. Investors should only consider buying this contract in conjunction with a tax-qualified retirement plan or an IRA for the annuity’s insurance features, such as lifetime income payments.
2 For some annuities, you can start taking withdrawals before the surrender charge period is over, as most contracts allow for a certain amount of free withdrawals to be taken annually while in your contingent deferred sales charge (CDSC) period. If you go over that amount, you can still take the withdrawal, but you will be assessed the charge.