An annuity is a financial contract between you and an insurance company. In exchange for a lump sum payment or a series of payments, the insurer agrees to provide you with regular income payouts, either immediately or at a later date.
Annuities have long been praised as a method to generate guaranteed income in retirement. However, individuals purchase annuities for various reasons, including the opportunity to defer taxes and allocate funds into an account with no contribution limits.
Here are the top reasons why people choose to invest in annuities and the factors to consider before making a decision.
1. Guaranteed income
The primary advantage of an annuity is the ability to create a guaranteed income stream. This ensures that you will receive regular payments for the duration of your life, regardless of your lifespan. This can be particularly beneficial if you are concerned about outliving your savings.
“For individuals who prioritize safety and consistency over opportunity cost, annuities can be an excellent fit,” says Sean Williams, a certified financial planner and principal at Cadence Wealth Partners. “Annuities offer a steady, predictable paycheck to complement their Social Security benefits.”
According to a 2023 survey by LIMRA, the largest insurance trade association in the U.S., the opportunity to generate guaranteed income was the primary reason individuals cited for purchasing annuities. Most buyers intended to use the annuity to supplement their Social Security or pension payments or to secure lifetime income.
Many individuals worry about depleting their retirement savings because the length of their life is uncertain. Annuities can provide peace of mind by guaranteeing a consistent income stream, even if you live well into your 90s or beyond.
Unlike other investments, annuities come with a guarantee due to being financial contracts issued by insurance companies. While other investments may offer higher returns, they also involve higher risks.
It is crucial to choose an insurance company with a strong financial standing when considering an annuity. Look for providers with a positive reputation and good customer feedback to ensure the safety of your investment.
2. No contribution limits
Qualified annuities, like traditional retirement plans such as a 401(k), have annual contribution limits. However, nonqualified annuities, which are funded with after-tax dollars, do not have contribution limits.
While individual life insurance companies set maximum funding amounts for annuities, nonqualified annuities purchased outside of retirement accounts are not subject to IRS-imposed contribution limits. This allows you to contribute as much as you desire to an annuity, up to the maximum set by your life insurance company.
This can be advantageous for affluent individuals seeking to increase their retirement savings beyond the limits of other accounts like a 401(k) or Roth IRA. It also makes annuities an appealing choice for individuals who have recently received a substantial inheritance or windfall, such as lottery winnings.
3. Tax deferral
Annuities offer tax-deferred growth until you withdraw the funds or begin receiving payments. With a nonqualified annuity funded with after-tax money, you only pay income tax on the profits, not the principal, upon withdrawal.
While many other investment accounts also defer taxes on earnings, such as 401(k)s, IRAs, and 529 plans, annuities do not provide unique tax benefits in this regard. Roth IRAs, for instance, allow tax-free withdrawals in retirement, offering more advantageous tax benefits compared to annuities.
Purchasing an annuity within a Roth IRA or Roth 401(k) allows for entirely tax-free payouts. However, many experts caution against stacking tax-advantaged accounts, as it may not be the most efficient strategy.
4. Set it and forget it
Once you acquire an annuity, you no longer need to manage your investments or withdrawal strategies. The annuity provider handles all aspects of portfolio management for you. This can be a significant relief if you are not comfortable managing your own investments or prefer a simplified retirement plan.
“The emotional aspect of financial planning is often overlooked,” says Williams. “Creating a secure and stable environment with an annuity can offer certain individuals more freedom and satisfaction during their retirement years.”
With an annuity, you can receive regular payments regardless of market fluctuations, providing peace of mind. By entrusting the management of your investments to an insurance company, you can save time and potentially reduce stress in the process.
“Ultimately, the decision to invest in annuities is not solely based on calculations, as other options may offer better returns,” notes Williams. “It is a decision based on the investor’s mindset.”
5. Customized to fit your needs
Annuities can be tailored to meet various requirements depending on your specific circumstances. Many annuities include a death benefit, akin to life insurance, which pays out to beneficiaries upon your passing.
While annuities are commonly associated with lifetime income, contracts can be structured for shorter periods, such as five or ten years. Additionally, different types of annuities are available, including fixed annuities linked to prevailing interest rates and variable annuities tied to underlying investment performance.
Survivor benefits are offered by some annuities, extending payments to a surviving spouse for a designated period after your death. Additional riders can also be added to customize annuities with insurance-like benefits, although these enhancements typically come at an extra cost.
The flexibility of annuities allows you to tailor the contract to your preferences, but it is important to note that additional features may increase the overall cost.
Downsides of annuities
While annuities can provide a guaranteed income stream in retirement, they also come with significant drawbacks. Before investing in an annuity, it is crucial to consider the following factors.
Complexity and fine print
Annuities are known for their complex contracts, which can span numerous pages. These documents outline details regarding payment schedules, withdrawal fees, payment amounts, interest rates, and other essential information.
Understanding your rights and obligations as an annuity holder requires thorough review of the contract, which can be time-consuming and challenging. Seeking guidance from a fee-only financial advisor can be beneficial when navigating through the contract.
Commissions and fees
Most annuities come with significant sales commissions embedded within the product. While these commissions may not be paid upfront, they can diminish your overall returns. Commissions typically range from 5% to as much as 10% of the invested amount.
The potential for substantial commission earnings can incentivize insurance agents to aggressively promote annuities, even if they may not be the most suitable product for your specific financial situation.
Illiquid
Annuities often restrict access to your funds for an extended period. While you may receive income payments and potentially withdraw some of the principal, accessing your funds can be limited and costly. This can pose a challenge in situations where you require funds for emergencies without adequate income or savings to draw from elsewhere.
Bottom line
Annuities can be a viable option for individuals seeking a guaranteed income stream in retirement. However, it is essential to carefully weigh the pros and cons before making a decision. If you are contemplating investing in an annuity, consult with a financial advisor to explore your options.
Editorial Disclaimer: All investors are encouraged to conduct their own independent research on investment strategies before making investment decisions. Additionally, investors are advised that past performance of investment products is not indicative of future price appreciation.