It is important to understand the basics of annuities before you make any decision about their worth. Annuity rates are currently very low, and as such, it may be more difficult than ever to generate an income using your money. There are a number of factors that affect annuity rates, including interest rate fluctuations, market condition and inflation/deflation expectations.
This article aims to decipher whether or not an annuity is right for you.
Related: How to find a financial planner
What is an annuity?
In the past, companies offered pension plans as part of a comprehensive compensation package. Employees love pension plans as they offer a near-guaranteed income in retirement. However, plans have fallen out of style as the number of companies offering pension plans is far less than before. That’s where an annuity comes in.
An annuity is a tax-efficient contract between you and an insurance provider. You make an upfront payment, and in exchange, the company pays you a monthly amount, usually in retirement. And you can use the money for whatever you like. While annuities are more like insurance products (as opposed to investment products), they are providing to be less popular than in previous years because annuity rates have been so low.
While many annuities do not allow you to access any money until retirement age, some do provide more flexible options.
What are the different types of annuities?
There are three types of annuities; fixed, fixed-indexed and variable.
A fixed annuity is a type of annuity where the payout amount remains constant throughout the annuity’s lifetime. This type of annuity is usually recommended for retirees who need a steady stream of income that doesn’t change. And while it’s the least risky of the three, it also comes with the smallest interest rate. For example, according to Annuity.org, five-year rates currently cover around 2%, while five-year CD rates currently pay about 1%.
A fixed-indexed annuity is a product where the monthly payments are linked to a stock market index, such as the S&P 500. Increasingly, insurance companies are using put options to hedge against a downturn. As a result, fixed-indexed annuities may offer a “minimum” monthly payout. This way, should the index tank, the minimum payout could remain in place. Considering that on average, the S&P 500 appreciates roughly 10% a year, this could offer a good balance to retirees who have other income sources.
Variable annuities, on the other hand, have the interest rate set based on the performance of an investment portfolio. When the portfolio does well, payments from variable annuities can increase. Similarly, when the portfolio reduces in value, so can the monthly payment. This is the riskiest option of the three, as there is always an (albeit unlikely) chance your annuity can go to zero.
There are advantages and disadvantages associated with all three types of annuities. However, when purchasing an annuity it is important that you weigh the risks involved with the product.
Related: What is a fiduciary?
What are the different types of annuity payout options?
There are two different types of annuities payout options: immediate and deferred.
Beneficiaries of immediate payout annuities are resulting from a lawsuit, lottery winnings or even an inheritance from a loved one. However, deferred payout annuities are those that start to pay out at some point in the future. And they are generally more common as they typically payout at retirement age, or at 59 ½.
Are annuities a tax-free product?
In general, beneficiaries will pay tax on the amounts received from the annuity. And withdrawing from the annuity before 59 ½ will often result in a withdrawal penalty. Having said that, all the capital gains, dividends, interest income, etc. received in the annuities’ portfolio will grow tax-free. Like with any potential tax burden, it’s always best to discuss the options with your tax professional before making any quick decisions.
Annuities can offer retirees stable income in the form of distributions in retirement. With an annuity, the retiree needs to know how much they’ll get, and for how long. The rest is up to the insurance company to deliver on the contract.
- Planning for retirement: How to get started
- Financial planner vs retirement planner: What’s the difference?
- How to find a financial planner
This article was produced and syndicated by MediaFeed.org.