When Is the Best Time to Buy an Annuity for Retirement?

An annuity is a contract with a financial institution where you provide a sum of money, either as a lump sum or through a series of payments. In return, the institution promises to deliver regular payments to you in the future, often for the duration of your life.

Evaluating Your Retirement Income Needs

Understanding your financial landscape in retirement is a foundational step before considering income-generating products. Begin by estimating your future living expenses, which fall into two categories: essential and discretionary. Essential expenses include housing, food, utilities, and healthcare, which remain relatively constant. Discretionary spending covers activities like travel, hobbies, and dining out, which can be adjusted based on your financial situation. It is common for people to need between 70% and 80% of their pre-retirement income to maintain their standard of living.

Assess your current and projected income sources in retirement. These include Social Security benefits, pension plans, and withdrawals from tax-advantaged accounts like 401(k)s and Individual Retirement Accounts (IRAs). Social Security replaces about 40% of pre-retirement income. Comparing your estimated expenses to these income sources helps identify any potential income gaps. Many individuals seek a “guaranteed income floor” to cover their essential expenses, ensuring a predictable stream of funds regardless of market fluctuations. This assessment helps determine if an annuity can bridge income shortfalls or establish that desired income floor.

Considering Annuities During Pre-Retirement Years

Purchasing an annuity during your pre-retirement years involves using deferred annuities. These contracts are designed to grow your savings on a tax-deferred basis, meaning you do not pay taxes on the earnings until you begin receiving payments. This tax deferral allows your money to potentially compound more efficiently over time. Many deferred annuities offer significant flexibility in terms of contributions, often without the strict annual limits found in other retirement accounts like 401(k)s or IRAs.

This strategy is particularly relevant if you have already maximized contributions to other tax-advantaged retirement vehicles and are looking for additional avenues to save. Deferred annuities can help diversify your future income sources, reducing reliance solely on market-dependent investments. They allow you to lock in a future income stream or grow your savings with a long-term perspective, without the immediate need for income. If withdrawals are made from a deferred annuity before age 59½, the earnings portion is subject to ordinary income tax and an additional 10% federal tax penalty, unless an exception applies. Surrender charges, which can be around 7% initially and decrease over several years, may also apply if you withdraw funds too early.

Purchasing Annuities at or Near Retirement

Individuals approaching retirement or those who have just retired often consider annuities for immediate or near-immediate income generation. This phase is characterized by a desire to convert accumulated savings into a reliable income stream. Immediate annuities, also known as single premium immediate annuities (SPIAs), are well-suited for this purpose as they begin making payments within one year of purchase. You typically fund an immediate annuity with a lump sum, which can then provide a guaranteed income for life or a specified period.

A significant advantage of purchasing an annuity at this stage is mitigating “sequence of returns risk.” This risk refers to the potential for negative market returns early in retirement, which can significantly deplete a portfolio when withdrawals are made. By converting a portion of your savings into an immediate annuity, you establish a predictable income stream that is not subject to market fluctuations, thereby protecting your essential expenses from early market downturns. This approach allows other retirement assets to potentially recover from market volatility without forcing you to sell investments at a loss.

Utilizing Annuities in Post-Retirement

For those who have already been retired for some time, annuities can still play a role, particularly in addressing longevity risk. Longevity risk is the concern of outliving your retirement savings. Annuities provide a guaranteed income stream for life, offering a solution to this concern by ensuring payments continue no matter how long you live.

An annuity can provide supplemental income if other retirement savings start to dwindle, or if unexpected expenses arise, such as rising healthcare costs. Some deferred annuities, specifically called longevity insurance annuities, are designed to begin payments at a very advanced age, providing a financial safety net for later years. This strategy can offer peace of mind, knowing that a portion of your income is secured for your entire lifespan, allowing for more confident management of remaining assets.