Annuities: Worth Another Look

An annuity is a contract between you and an insurance company that is marketed to provide predictable income in retirement, often to address the risk of outliving savings. The insurance company pays you a fixed or variable income, often through guaranteed periodic payments for either a specified period or your lifetime. Annuities shift a portion of investment risk away from you and onto the company.

Annuities are useful if you’ve maxed out your yearly contributions to qualified retirement plans but would still like to add to savings, because they are not subject to IRS annual contribution limits.

There are two basic types of annuities:

• Income annuities offer payouts over the course of your lifetime or for a set time in return for a lump-sum investment.
• Tax-deferred annuities let you accumulate savings on a tax-deferred basis, with the option for lifetime income. (Some tax-deferred annuities may impose surrender charges or penalties for early withdrawals.) You may access a tax-deferred annuity’s assets in one of two ways:
  • By converting the annuity to an income annuity when you retire. This will allow you to spread out the tax burden, likely leading to lower taxes on your long-term gains.
  • By taking withdrawals without converting the tax-deferred annuity to an income annuity. However, if you choose this option, your gains will be taxed at ordinary income tax rates.

Annuity products include:

• Tax-deferred fixed annuities. These have a fixed rate of return that is guaranteed for a set period by the issuing insurance company. The insurance company bears the risk of market fluctuations, and the interest credited to the annuity is agreed upon when the contract is issued.
• Tax-deferred variable annuities. These have a rate of return that goes up or down depending on the fund-like subaccounts you choose, which may include stocks, bonds or money market funds. The rate of return fluctuates with the performance of the chosen investments, and there is the potential for gains or losses based on market performance.
• Fixed indexed annuities. These provide a return based on the performance of a specific market index such as the S&P 500. The investor is not invested in the market index, but earns interest based on a formula linked to the index’s performance. Indexed annuities typically cap the maximum return and provide a floor to limit potential losses.

Separating fact from fiction

You may have heard that annuities are complicated and come with high fees. However, there is a wide range of annuities. Some annuities are not complicated and offer lower fees yet still help you achieve specific financial goals.

Annuities work to mitigate the risk of market volatility risk, which means that they can be an important part of your retirement investment strategy. Annuities may be your only investment or they may be part of a conservative investment portfolio; many people use annuities to protect a portion of their principal while investing the remaining assets in growth securities. This helps protect principal while retaining the potential for growth.

Tax-deferred variable annuities may also be used as a wealth transfer tool. Some insurance companies offer a feature called a “stretch option” or “nonqualified stretch annuity.” This feature allows a nonspousal beneficiary to continue deferring taxes on the annuity’s gains while receiving payments over their lifetime (based on life expectancy), which potentially reduces the tax impact of a lump-sum inheritance. However, this option isn’t universally available, and the SECURE Act of 2019 has made changes to how inherited retirement accounts are treated.

Because an annuity’s payouts are subject to the claims-paying ability of the issuing insurance company, it’s important to choose a financially strong firm. Annuities are not backed by any government insurance.

It’s also important to research the different kinds of annuities to make sure they fit with your financial strategy. Be sure that you understand all the fees, charges, expenses and potential penalties. Consult a professional before you purchase an annuity contract.