Is Now a Good Time to Buy an Annuity?

Annuities provide a steady income stream, often for retirement. Deciding to acquire one is complex, influenced by economic conditions and personal finances. This article explores factors shaping an annuity’s suitability and financial implications.

Understanding Annuities

An annuity is a contract where an individual pays an insurance company for regular disbursements, typically in retirement. It offers a predictable income stream, helping to prevent outliving savings. Annuities have two phases: accumulation and payout. During accumulation, funds grow, often tax-deferred, until income begins.

The payout phase, or annuitization, converts accumulated funds into periodic payments. These can last for a set period, the annuitant’s life, or two lives. The insurer invests premiums and distributes returns and principal.

Types of Annuities

Annuities vary in how value and payouts are determined.
Fixed annuities offer a guaranteed interest rate for a set period, providing predictable payments.
Variable annuities let owners invest premiums in sub-accounts. Value and payouts fluctuate with these investments, offering growth potential with market risk.
Indexed annuities link returns to a market index, like the S&P 500, without direct investment. They include participation rates (how much gain is credited) and caps (maximum return). They offer some principal protection during downturns.

Payment Start Categories

Annuities are also categorized by when payments begin.
Immediate annuities require a lump-sum payment, with income starting within one year. They suit those at or near retirement needing immediate income.
Deferred annuities allow contributions over time or as a single premium, with payments scheduled for a future date. This type is for long-term growth.

Economic Influences on Annuity Value

Economic conditions influence an annuity’s financial outcomes. Interest rates, inflation, and market volatility impact performance and payouts.

Interest Rates

Interest rates affect guaranteed payouts for fixed annuities and crediting rates for indexed annuities. Higher rates allow insurers to invest premiums more favorably, leading to better guaranteed rates for new fixed contracts and potentially higher caps or participation rates for indexed annuities. Conversely, low rates mean less appealing guaranteed rates for new fixed annuities and potentially lower indexed annuity returns.

Inflation

Inflation can erode the purchasing power of fixed annuity payments. A fixed income stream adequate at retirement may become insufficient if inflation increases living costs. Some annuity contracts offer optional inflation riders, adjusting payments upward to mitigate this. These riders cost extra and provide some protection against rising prices, helping preserve payment value long-term.

Market Volatility

Market volatility primarily influences variable and, to a lesser extent, indexed annuities. During market swings, variable annuity sub-account performance fluctuates, impacting cash value and future income. For indexed annuities, volatility can influence insurer-offered caps and participation rates. In volatile markets, insurers may adjust these, affecting upside potential. Indexed annuities offer some downside protection, but returns are tied to market movements.

Personal Financial Alignment with Annuities

An individual’s financial situation and goals determine if an annuity is suitable. Considerations include retirement income needs, age, risk tolerance, liquidity, and existing financial portfolio.

Retirement Income Needs

Annuities provide a reliable income stream that complements other retirement sources like Social Security or pensions. They can help cover essential living expenses, offering income stability distinct from fluctuating investment portfolios.

Age and Proximity to Retirement

Age and proximity to retirement influence the choice between immediate and deferred annuities. Younger individuals planning for retirement might favor deferred annuities for tax-deferred growth. Those at or nearing retirement, needing immediate income, may find immediate annuities more appropriate.

Risk Tolerance

Risk tolerance affects annuity type selection. Individuals with low investment risk tolerance might prefer fixed annuities due to guaranteed rates and predictable payments. Those comfortable with market fluctuations and seeking higher growth may consider variable annuities. Indexed annuities offer a middle ground with market-linked returns and some downside protection.

Liquidity

Annuities are illiquid; funds are not easily accessible without penalties. Individuals needing significant access to capital for unexpected expenses might find this restrictive. The trade-off between guaranteed income and accessibility is important.

Overall Financial Portfolio

An annuity should fit within an individual’s overall retirement savings and investment strategy. It can diversify a portfolio, providing a stable income component that balances more volatile investments like stocks.

Taxation and Expenses of Annuities

Understanding annuity tax treatment and costs is important for financial assessment. These elements impact net return and financial viability. Considerations include tax-deferred growth, withdrawal taxation, penalties, and fees.

Tax-Deferred Growth

Annuity earnings grow tax-deferred. Income and capital gains are not subject to annual taxation. Taxes are due only upon withdrawals or income payments, typically in retirement when an individual may be in a lower tax bracket.

Taxation of Withdrawals

Withdrawal taxation depends on whether an annuity is qualified or non-qualified. Qualified annuities, funded with pre-tax dollars (e.g., within an IRA), have all withdrawals fully taxable as ordinary income. Non-qualified annuities, funded with after-tax dollars, tax only the earnings portion of withdrawals.

For non-qualified annuities, the IRS generally applies the “last-in, first-out” (LIFO) rule. Earnings are withdrawn first and taxed as ordinary income before original principal contributions are returned. Subsequent principal withdrawals are tax-free.

Early Withdrawal Penalty

A 10% IRS penalty may apply to withdrawals from an annuity before age 59½, in addition to ordinary income tax on earnings. This discourages short-term savings. Exceptions exist for disability, death, or substantially equal periodic payments.

Fees and Charges

Annuities include fees and charges that impact returns. Surrender charges apply if funds are withdrawn or the contract is surrendered within a specified period, often five to ten years. These charges typically decline over the surrender period.

Variable annuities often include Mortality & Expense (M&E) fees, covering insurance costs for guaranteed death or living benefits. These fees are a percentage of the annuity’s account value, deducted annually. Administrative fees may also be charged for contract management.

Many annuities offer optional riders for enhanced features, such as guaranteed income for life or enhanced death benefits. These riders come with an extra cost, deducted from the annuity’s account value.

References

1. IRS. (n.d.). Topic No. 410 Pensions and Annuities. Retrieved from https://www.irs.gov/taxtopics/tc410