An annuity is a contractual financial product that is designed to accept and grow funds from an individual and then pay out a stream of payments to the individual at a later point in time. It’s a catch-all term for an investment that pays out sums of money over a long period of time, or even over a lifetime. When used as part of a larger retirement strategy, annuities are a popular choice as a source of supplemental income.
As a financial product, it has some important advantages over investing in stocks and bonds or mutual funds. It is generally regarded as a safe investment alternative that includes interest rates that are guaranteed for the term of the contract, tax deferral, and an option to have guaranteed income for life.
Here’s how it works. You make an investment in an annuity and it makes payments to you on a future date or series of dates. It can pay you monthly, quarterly, annually, or in a one-time lump sum. You can choose to receive payments for a set number of years, or for the rest of your life. The amount you receive depends on whether you opt for a guaranteed payout, called a fixed annuity, or a payout stream determined by the performance of your annuity’s underlying investments, called a variable annuity.
The fixed annuity is essentially a tax deferred certificate of deposit, or CD-like investment issued by insurance companies. Just like CDs, they pay guaranteed rates of interest, in many cases higher than bank CDs. The convenience of a set payout makes a fixed annuity a popular option for retirees who want a guaranteed income stream to supplement their other retirement income.
A variable annuity is a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and later pays you a stream of income in retirement that is determined by the performance of the investments you choose. Because the performance of your chosen investment vehicles is not guaranteed, neither is the amount of your payout.
Annuities offer several advantages over other investment strategies. One of the biggest advantages to annuities is that the money you invest is tax-deferred. When you eventually make withdrawals, the amount you contributed to the annuity is not taxed, but your investment earnings are taxed at your regular income tax rate. Another advantage of annuities offer is that they allow you to sock away a larger amount of cash. Unlike other tax-deferred retirement accounts, such as 401(k)s and IRAs, there is no annual contribution limit for an annuity. You can put away as much money as you want toward your retirement. That’s particularly useful if you’re close to retirement age and need to catch up. All the money you invest compounds year after year without the yearly tax bill from Uncle Sam. That ability to keep every dollar invested working for you is a big advantage over taxable investments.
There are disadvantages to consider as well. Annuities typically come with an initial commission fee, annual maintenance fees, and an early surrender fee if take money out before the end of its term. You will want to compare the costs with those of other investments and ask lots of questions as you decide. You will also want to factor in the peace of mind that comes from removing the risk of other types of financial vehicles as well.
If you have maxed out other tax-advantaged retirement investment vehicles, such as 401(k) plans and IRAs and have additional money to set aside for retirement, an annuity’s tax-free growth may make sense.
The folks at Freedom Insurance care about you and your retirement. We’re here to help with those tough decisions. Call us today!