Sure, let’s break down this retirement and investment stuff into simpler terms.
So, you’ve got a 401(k) and a Roth IRA, right? That’s a good start for your retirement plan. But, there’s always more you can do to make sure you’re set for a comfy life after work. You see, if you live longer than you think or face unexpected costs in retirement, you might run out of savings. And don’t think Social Security will cover it all – it probably won’t be enough to keep up your lifestyle.
Here’s where an annuity might come in handy. It’s like a safety net, giving you a guaranteed income for your golden years. But, you gotta make sure it’s the right fit for you.
So, what’s an annuity? It’s a contract where one party agrees to pay the other a certain amount of money for a set period. Annuities have been around for ages. Nowadays, they’re usually offered by life insurance companies to individual contract owners, or beneficiaries.
The main idea behind an annuity is to protect you from outliving your income. Say your retirement savings and Social Security only cover you until you’re 85. An annuity makes sure you’re taken care of for the rest of your life, whether you live to 90, 95, or beyond.
An annuity guarantees to pay out a minimum amount at a set frequency, like monthly, quarterly, or yearly. These payments keep coming even after they exceed the total amount you paid into the contract, plus any interest or gain. But, some annuities have a set term, meaning payments stop after a certain number of years.
Regardless of the term length, all annuities are long-term investments best suited for retirement income. Payments usually don’t start until you’re well into your golden years, and you can’t withdraw funds from an annuity without penalty until you’re 59 ½.
How do annuities work? Depending on your contract, you can make a lump-sum payment or a series of payments into the contract. The insurance company uses your payment(s) to buy accumulation units – basically, shares of the annuity – that grow over time.
In some cases, you can start getting annuity payments right away. More often, you’ll wait until you reach a certain age set by the contract. The longer you wait to get payments, the more time your money has to grow. You can access the money you paid into the annuity under certain circumstances, but you might face a penalty for withdrawals made before age 59 ½.
Before you can get any payments, the insurance company has to convert your accumulation units into annuity units. This is called annuitization. After annuitization, you can’t access the lump-sum amount you paid into the annuity. But, you’re now entitled to receive guaranteed income for the rest of the contract’s term.
You can buy an annuity contract directly from an insurance company or inside a tax-advantaged retirement plan, like an IRA or qualified plan. You make your initial payment and any subsequent payments by check or electronic transfer. You can also buy an annuity through a 1035 exchange, a tax-free transaction that converts an existing annuity or cash value life insurance policy into a new annuity.
Annuities have some common characteristics. They grow on a tax-deferred basis, even if they’re not held in an IRA or qualified plan. This makes them different from most other types of long-term investments, like stocks and corporate bonds.
Annuities typically have high investment limits, often well over $1 million. This makes them suitable for high net worth individuals looking to reduce taxes on long-term savings.
Like cash value life insurance policies, annuities usually have surrender charges during the first five to 10 years. These charges can be steep early on, but they decrease over time and eventually disappear. Some insurance companies allow annuity holders over age 59 ½ to withdraw a certain principal amount each year, up to 20% in some cases.
You may be able to avoid taxes and penalties on annuity withdrawals by rolling your annuity over into a new contract using a 1035 exchange.
Once annuitization happens, you can usually choose from several payout methods. Check your annuity contract for specific information about your options.
Your annuity contributions grow on a tax-deferred basis unless you withdraw them before turning 59 ½. If you withdraw before that point, you’ll pay a 10% tax penalty on the withdrawal amount, plus ordinary income taxes on interest or gains. You don’t pay tax on annuity principal withdrawals.
After age 59 ½, annuity distributions are only subject to ordinary income tax on the interest or gains they earned.
Annuities come in several different forms. Before entering into an annuity contract, read the agreement and fine print carefully. Insurance agents and financial advisors who sell annuities often work on commission, so there’s no guarantee that the contract is in your best interest. If you’re not sure, have an insurance attorney or fee-only fiduciary advisor review it.
Annuities have their pros and cons. They offer guaranteed income in your later years, which is great. But they’re also complex and have some notable drawbacks.
Before investing in an annuity, consult a fiduciary financial advisor to make sure it’s the right move for you. It could be, but don’t just take the word of the person selling it, who stands to make a hefty commission off your decision.
