Annuities are often misunderstood retirement planning vehicles. If you’re considering an annuity, you need to recognize that there is more than one kind of annuity, and they are not a one-size-fits-all retirement solution.
What Is an Annuity?
The U.S. Securities and Exchange Commission (SEC) defines an annuity as a contract between you and an insurance company. An annuity requires that the insurer make payments to you, either immediately or in the future, depending upon which financial product you buy.
You can purchase an annuity by making either a single payment or a series of payments. Annuity payouts can come in a lump sum or in a series.
What Are the Different Types of Annuities?
There are three different types of annuity contracts:
- Deferred annuity. These lump-sum or incremental investments, pay the buyer starting on a fixed date (date-certain) after the insurance company receives the funds.
- Immediate annuity. These lump-sum investments start paying out to the buyer very shortly after the insurance company receives the funds.
- Qualified longevity annuity contract (QLAC). Funded with a one-time lump-sum payment from IRA accounts or a 401(k) balance, these specialized deferred annuities offer guaranteed periodic payments for the remainder of your lifespan, starting between ages 72 and 85. (The longer you wait for your payout, the larger the payments you’ll receive. You are allowed to invest up to 25% of your total IRA or 401(k) balance to a maximum of $135,00, whichever is less.)
Once you determine the type of annuity that is best for your needs, you can structure them into three forms:
- Fixed annuity. These annuities feature a predetermined minimum interest rate plus fixed periodic payments that will neither increase nor decrease over time. (Regulated by state insurance commissions.)
- Indexed annuity. These annuities combine features of securities and insurance products. The investment grows (or decreases) corresponding to the performance of a particular stock market index, such as the S&P 500 Index, NASDAQ, or S&P 500 Index. (The annuity funds are not “in” any index, but the annuity interest is credited as the chosen index moves upward. If the index loses money, your annuity receives no credit. Your principal, previously credited interest, and locked-in gains are never lost due to market fluctuation.)
- Variable annuity. These investments offer scheduled payouts, the amount of which can vary based on the performance of the underlying mutual funds to which the annuity is tied. Your insurance company allows you to direct your payments to different investment options, usually mutual funds. The SEC, which regulates this type of annuity, says “payouts can vary depending upon how much you put in, the rate of return on your investments, and expenses…If you are investing in a variable annuity through a tax-advantaged retirement plan, such as a 401(k) plan or an IRA, you will get no additional tax advantages. Consider buying only if it makes sense because of the annuity’s other features.”
Each type of investment carries a level of risk. The SEC warns that “you should consider the financial strength of the insurance company issuing the annuity. You want to be sure the company will still be around, financially sound, during your payout phase.”
How an Annuity Works
There are two phases to annuities: the accumulation (funding) phase, and the payout phase.
During the accumulation phase, you fund your annuity in a variety of ways. You can invest a lump sum using funds from your IRA or 401(k) or funds from another investment account. During this phase, the money invested is “illiquid,” meaning you have no access to it. The time your money is not available is called the surrender period. Should you need to access your funds during this period, you’ll experience significant fees, penalties (surrender charges), and taxes.
During the payout phase, you get your payments back along with any gains and investment income. This payout can be made in a lump sum or in a series of payments, generally monthly.
Fees Associated with Annuities
Throughout the life of your investment, you will pay several charges, including:
- Administrative fees. These fees may be a flat annual fee or a percentage of your account value.
- Mortality and expense risk charges. These charges will be equal to a certain percentage of your account value, typically 1.25 percent per year.
- Withdrawal penalties. These penalties will be levied if you withdraw money before age 59½, including a 10% IRS tax penalty on top of taxes you owe on the income.
- Additional fees and charges. These extra fees are typically applied for special features, like long-term care insurance or guaranteed minimum income benefits. Initial sales loads, transfer fees, and other fees may apply.
- Underlying fund expenses. Fees and expenses attached to underlying mutual fund investments.
Is an Annuity Right for You?
Annuities provide three specific benefits:
- Periodic payment for a specified amount of time. The payments could be for the rest of your life or your beneficiary’s life.
- Tax-deferred growth. Until you begin receiving your payments, you will pay no taxes on the income or investment gains.
- Death benefits. Should you die before you start receiving payments, your beneficiary receives a specific payment.
What annuities don’t provide is regular access to your invested funds during the accumulation phase. If you need to access your funds regularly, an annuity is probably not right for you because of the withdrawal penalties.
If you do not have an immediate need to access your invested funds and are looking for a stable, guaranteed retirement income or you have a beneficiary who needs help managing funds, an annuity can be a helpful tool.
For annuities or other securities investments, make sure your broker-dealer or investment advisor is registered by using the SEC’s free search tool on Investor.gov.
Finance of America Reverse LLC is a reverse mortgage lender that offers reverse mortgage loans. It does not offer annuities or require any reverse mortgage borrower to obtain an annuity, and this article is not a solicitation for any annuity product. Reverse mortgage borrowers are required to disclose whether they plan to purchase an annuity during the loan origination process. This article provides general information about annuities that you may wish to consider and is based on general discussions with third-party financial professionals.
Seniority is published by Finance of America Reverse LLC. The views expressed in this publication are those of the author alone and do not necessarily reflect the views and opinions of Finance of America Companies. This article is intended for general informational and educational purposes only and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.
