How does an annuity work?
As a retirement income planning tool, annuities are the subject of much discussion these days. As a means of generating retirement income, they can be very useful. Yet annuities come in many shapes and sizes and are not a “one size fits all” financial instrument.
Annuities can be fixed or variable, and either of those can be deferred or immediate. With a fixed annuity, the insurance company guarantees a set interest rate of return on your premium for a specific amount of time. A variable annuity comes with investment options in which to invest your premium for financial market growth potential. Payments under an immediate annuity can begin either right after you purchase the annuity or may be postponed up until 12 months later. Payments under a deferred income annuity are delayed and can begin at some future time you select.
It’s no wonder that many people are left scratching their heads when contemplating annuities.
So just what is an annuity?
Let’s start at the beginning. Put simply, an annuity is a contract between an individual and an insurance company. The individual gives the company a sum of money (the premium), and in return is promised a periodic payout for a stated length of time or their lifetime. Some annuities enable you to invest in the market, while others do not. There is no legal limit to the amount you can contribute to an annuity, but contributions are not tax deductible. Taxes on any earnings are deferred until you make withdrawals and at that time you will pay ordinary income taxes on gains. There is a 10% penalty if you withdraw earnings before age 59 ½.
Consider your purpose for buying an annuity
What has drawn your attention to annuities? Did your neighbor or co-worker just purchase one? Did your financial professional talk to you about them? At best an annuity should complement the other holdings in your retirement strategy, but the bottom line remains – annuities can provide guaranteed income for your future.
Consider your time horizon and life expectancy
Annuities are designed to be long-term retirement financial strategy tools and can be a means of transferring the risk of outliving your retirement nest egg. Deferred annuities allow you to delay taking income until sometime in the future but consider carefully if you might need those funds before the age of 59 ½. If you are on the edge or already in retirement, an immediate annuity can begin paying income shortly after purchase. Whether or not there is a longevity gene in your family, the U.S. has experienced 2
Consider your total retirement savings
Whether or not you were a supersaver during your working years, consider the percentage of your overall retirement savings you might put into an annuity. A retirement strategy should contain a cash reserve to cover emergencies or other contingencies. Since annuities typically impose a surrender charge on any withdrawals made in the years following a premium payment (typically seven years or less) and have limited liquidity, especially once a contract is annuitized, it may be appropriate to only put a portion of your retirement savings into an annuity.
Consider your overall long-term retirement financial strategy
Most workers already have one source of guaranteed income in the form of Social Security. Some may feel confident they can efficiently invest their savings to supplement Social Security while others may prefer another source of guaranteed income to feel financially confident. For those who find watching the effects of the ups and downs of the investment markets on their retirement savings a little unnerving, annuities can offer benefit guarantees that other financial instruments cannot.
Consider the type of annuity
Before making any decision, do your homework. Consider carefully what your current circumstances are and what you plan or anticipate for the future. Be sure to consult with your financial professional or, your legal or tax professional before making any purchase.
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