Common Misconceptions: The Pros and Cons of Annuities
There are a lot of misconceptions surrounding annuities. Are annuities right for me? If so, what type is best?
So how does an annuity work? If you’ve heard the term “annuity” being thrown around and aren’t very clear on what it means, you’re not alone.
From what they are and what they aren’t, this guide has the pros and cons of annuities and what makes them so commonly misunderstood.
What Is an Annuity?
An annuity is essentially a contract in which you and your insurance company cover goals you may have, such as lifetime income, legacy plans, principal protection, or the cost of long-term care.
What makes an annuity different than other retirement investments is that it is guaranteed. No matter how long you live, an annuity can guarantee lifetime retirement income.
While the concept of an annuity is basic enough, there are certain rules and types of annuities that can get complicated.
How Does an Annuity Work Exactly?
Annuities work by transferring the risk to the insurance company instead of the owner. The owner is also known as the “annuitant”.
As with all forms of insurance, you pay the company a premium to bear the risk. To pay for your annuity, you may pay the annuity company in a lump sum or in the form of a series of payments.
How you pay your annuity depends on the type of annuity. The accumulation period refers to the period in which you pay your premium.
Annuity Payout Period
Thankfully, unlike other forms of insurance, you actually don’t keep paying this insurance forever. At a set time, you stop paying the insurance and instead the annuity starts to pay you.
When you enter this phase, your contract moves into the payout phase. In terms of your payments, there is a lot of flexibility there.
You can structure your annuity so that payments are triggered for a set number of years or even for your heirs, for example. You can also set them to extend for your lifetime, your spouse’s life and then have a payout period where any remaining funds go to a beneficiary.
Annuity Payments Explained
As mentioned above, the payment terms are where annuities can vary significantly. Just like with social security, your payments are based on life expectancy.
If you are expected to love for a longer period of time, your payments may be smaller over a longer stretch of time.
You can receive your payments annually, over a quarter, or each month, for example. You can also postpone receiving your payments for years or even decades. In some cases, you can also start your payments immediately.
The bottom line is that annuity payments can be customized to meet your needs. Before signing a contract, you can work with your investment professional to determine what is most important to you.
You’ll want to think about what contractually you want the money to do and also when you’d like it to start.
An Immediate Annuity
With an immediate annuity, it doesn’t start paying your annuity income right away. Instead, you make one lump payment to your insurance company and it will start to pay you income after one annuity period
The annuity period may be one year after you purchase or as soon as 30-days.
This period is based on when you have decided to receive your income payments. Let’s say you decided to purchase a monthly annuity, for example. This means you would receive your first income payment a month after you bought it.
For retirees, immediate annuities are a popular choice because payments can start so soon.
Fixed Deferred Annuity Can Provide Lifelong Income and Tax Advantages
If you select a deferred annuity, you won’t receive your payments for years or even decades. While time passes your premiums are allowed to grow without paying taxes inside the annuity.
People who go this route will usually use an annuity to plan for lifelong income as a supplement to employer-sponsored retirement income. Most people use these because there are no IRS limits imposed.
One of the only limitations in terms of how much income you can receive from an annuity is the amount the insurance company will accept for you.
In 2019, the IRS allowed for $130,000 or 25 percent of your retirement income to be funded by an annuity. This annuity is also known as a qualified longevity annuity contract or QLAC.
Early Withdrawal Penalties May Apply
In some cases, a deferred annuity may have early withdrawal penalties if you take your money out early. There will typically be surrender periods that vary and the charges associated with these timeframes go down as you get closer to your payment period.
Let’s say for example you have a deferred annuity with 10 years left on the surrender period. You may be charged 9% if you with drawl money next year and 8% the following year if you withdrawal early.
Keep in mind that with an IRA and 401(k) earnings that you withdraw before 59 and a half, you might have to pay a 10% federal tax penalty.
The same goes for income from an annuity where it is taxed as income in the year you earn it.
Pros and Cons of Annuities
As with any investment, there are always positives and drawbacks.
In terms of the pros and cons of annuities, one positive is that these investments are always guaranteed. This means that you will always receive your income because you have a binding contract laying out these terms.
While a drawback may be early withdrawal penalties and taxes, there are almost always these fees and taxes applied to any retirement income or investment.
When it comes to which type of annuity is right for you, fill out the contact form here to talk to a certified financial planner who is ready to help you find the best fit.