Whether you’re about to retire or have many more years to save up money, your current nest egg might not be large enough if you want to have a comfortable life during retirement. Of the numerous investments you can make to build your income, one solution that you might be interested in is an annuity. This guide covers everything you need to know about annuities and the advantages they offer.
What are Annuities?
An annuity is a type of contract between an insurance company and the contract holder. The insurance company promises to pay out a certain sum of money for a set amount of time. These funds are distributed periodically based on the contributions the contract holder provides. It’s common for investors to purchase annuities to obtain a stream of income during retirement.
The majority of annuities provide tax benefits. Until you withdraw on the income, earnings from the investment will be tax-free. The contributions you make can be tax-deferred for many years while the value of the annuity compounds.
While most annuity holders wait until retirement to start making withdrawals, investors can make withdrawals for specific purposes without incurring penalties. While every annuity contract differs, some contracts include provisions that allow withdrawals of 10-15% in a year without extra fees.
How Does an Annuity Work?
There are two primary categories of annuities, which include immediate and deferred annuities. If you purchase an immediate annuity, you will begin to receive payments immediately after you give the insurance provider a lump sum of cash. The payments you receive can be variable or fixed.
Investors might select an immediate annuity if they have recently been given a one-time windfall, which can be an inheritance. Buying an immediate annuity allows you to supplement the income you obtain from Social Security during retirement.
A deferred annuity is meant to help people build capital throughout their working life. This capital can be converted directly into an income stream during retirement. Deferred annuities can be purchased by making a lump sum payment or a series of contributions over an extended period of time.
Types of Annuities
Aside from the immediate and deferred categories of annuities, there are a few different types that you can choose from, which include indexed, variable, and fixed annuities.
An indexed annuity is designed to combine fixed annuity features with the potential to obtain extra investment growth based on market performance. A minimum return is guaranteed alongside a return that’s pegged to a rise in a market index. The amount that you can invest in the annuity is usually capped.
A fixed annuity gives you a consistent sum of income during retirement, which is a way to invest without taking on a high amount of risk. You’ll be given a specific amount of money each month for the remainder of your life or another set period, which could be anything from 5-20 years.
These annuities also provide a guaranteed return rate, which means that the risk associated with the annuity is affixed to the insurance provider instead of you. The main issue with a fixed annuity is that the insurance provider will benefit from a situation where investment markets have an unexpectedly great performance. When inflation is extremely high, a fixed annuity can lose some of its spending power.
Variable annuities give you a return that’s largely based on how a portfolio of various mutual funds performs. This portfolio will be selected by you. Depending on how your contract is written, the insurance provider can guarantee a minimum income stream. This type of annuity is viewed as a security through federal law, which means that it’s regulated by the SEC.
The many benefits of an annuity include:
- Earnings grow over time and remain tax-free
- A certain amount of penalty-free withdrawals are possible
- You could receive income for life
- Annuities can bypass the probate process
- You can reallocate some of the funds in variable annuities without paying fees
Annuities can be a meaningful part of your retirement plan. There are several types of annuities you can invest in, which gives you the ability to select the option that offers the most advantages.