Should I Get an Annuity? What You Need to Know

Annuities are financial contracts designed to provide a steady income stream, often during retirement. They offer a predictable source of funds later in life, helping individuals manage their finances. This article explores what annuities are and factors to consider for personal financial planning.

Defining an Annuity

An annuity is a written contract between an individual and an insurance company. Its primary purpose is to accumulate funds and then provide a series of payments over time, typically for retirement income.

Annuities generally involve two distinct phases. The first is the accumulation phase, where the individual pays premiums into the contract, and the funds grow on a tax-deferred basis. The second is the payout, or annuitization, phase, during which the individual begins to receive regular payments from the accumulated funds.

Annuity Structures and Payout Options

Annuities offer different structural approaches to income distribution. Immediate annuities begin making payments soon after the contract is purchased, typically within a year, in exchange for a single lump-sum premium. Conversely, deferred annuities allow funds to accumulate over a period of time, with payments commencing at a future, predetermined date.

Once an annuity enters its payout phase, several common options dictate how income is received. A life annuity provides payments for the annuitant’s entire life, protecting against outliving savings. A life annuity with a period certain guarantees payments for the annuitant’s life, and for a specified minimum number of years. If the annuitant dies before this period ends, beneficiaries receive the remaining payments. A joint and survivor annuity extends payments for the lives of two individuals, such as a married couple, ensuring income continues for the surviving partner.

Variations of Annuity Contracts

Annuity contracts vary in how their value grows and how payments are determined, aligning with different financial objectives. Fixed annuities provide a guaranteed interest rate on the premium, leading to predictable income payments. These contracts offer stability, as the interest credited during the accumulation period and the subsequent payments are set and not subject to market fluctuations.

Variable annuities link their value to the performance of underlying investment subaccounts, which can include stocks, bonds, or money market instruments. This structure introduces market risk, as the contract’s value and payout amounts can fluctuate based on investment performance, but it also offers the potential for higher returns.

Indexed annuities, sometimes called fixed indexed annuities, offer growth potential tied to a market index, such as the S&P 500. While their returns are linked to index performance, these annuities typically include a guaranteed minimum return, known as a floor, to protect against market losses. They also often have a cap or participation rate, which limits the maximum return credited, balancing downside protection with a defined upside potential.

Personal Financial Considerations for Annuities

Evaluating an annuity requires a thorough assessment of individual financial circumstances and objectives. One should consider how an annuity aligns with long-term financial goals, such as securing a guaranteed income stream for retirement, protecting against longevity risk, or achieving tax-deferred growth for future needs. Annuities can provide a reliable income that complements other retirement savings, like 401(k)s or IRAs, by offering a predictable cash flow.

An individual’s risk tolerance is also a significant factor. Fixed annuities appeal to those seeking predictable returns and minimal risk, while variable annuities suit individuals willing to accept market risk for potentially higher growth. Indexed annuities offer a middle ground, providing some market participation with downside protection. Annuities are generally long-term contracts, and accessing funds prematurely can lead to liquidity challenges, including surrender charges that typically start around 10% and decrease over several years.

The role an annuity plays within an existing retirement portfolio should be carefully examined. For individuals with substantial retirement savings, an annuity can diversify income sources and mitigate the risk of outliving assets. Personal health and longevity expectations can influence the perceived value of a lifetime income stream. Consulting with a qualified financial advisor is important to assess whether an annuity is appropriate for specific needs and to navigate the complexities of these contracts.

Tax Treatment of Annuity Earnings and Withdrawals

Annuities offer tax-deferred growth, meaning earnings within the contract are not taxed until withdrawals begin. When withdrawals are made, the earnings portion is subject to taxation as ordinary income, while the return of the original principal is not taxed.

The Internal Revenue Service (IRS) generally applies the “last-in, first-out” (LIFO) rule to annuity withdrawals, which means that earnings are considered to be withdrawn before the principal for tax purposes. Additionally, withdrawals made before age 59½ may incur a 10% IRS penalty, in addition to being taxed as ordinary income. Annuities can be either qualified or non-qualified. Qualified annuities are held within tax-advantaged retirement accounts, such as IRAs, and their original contributions typically have not been taxed. Non-qualified annuities are purchased with after-tax money, meaning the principal has already been taxed.