By Herb White, CFP, AIF, MBA, CLU, ChFC ~
You may have heard that IRAs and employer-sponsored plans (e.g., 401(k)s) are the best ways to invest for retirement. Thatâs true for many people, but what if youâve 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 insurance contract. The details on how it works vary, but hereâs 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, youâll 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.
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:
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). Theyâre known as annuitization options because youâve 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, your selected payout option, the length of the payout period, and your age if payments are to be made over your lifetime.
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:
But annuities arenât for everyone. Here are some potential drawbacks:
Choose the right type of annuity
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? Donât 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 youâre near retirement or already retired, an immediate annuity may be your best bet. This type of annuity starts making payments to you shortly after you buy the annuity, typically within a year or less. But what if youâre younger, and retirement is still a long-term goal? Then youâre 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 thatâs 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 selec