Who Should Buy Annuities for Their Retirement Plan?

Annuities are financial products designed for long-term financial planning, particularly for retirement. This article explores their nature, the financial objectives they address, and key factors individuals should consider when evaluating their suitability.

Understanding Annuities

An annuity is a contract between an individual and an insurance company, where the individual pays a premium (either a lump sum or a series of payments) and, in return, the insurer promises to provide a stream of payments, often for retirement. This financial arrangement involves two main phases: the accumulation phase and the payout phase. During the accumulation phase, the funds contributed to the annuity, along with any earnings, grow on a tax-deferred basis. The payout phase begins when the individual starts receiving payments from the annuity.

Annuities come in several common types, each with distinct characteristics regarding how they generate returns or provide income. A fixed annuity offers a guaranteed interest rate for a specified period, providing predictable returns and protection from market fluctuations. Variable annuities involve investment choices where returns fluctuate based on the performance of underlying investments.

An indexed annuity links its returns to a specific market index, offering potential for growth. Annuities are also categorized by when payments begin: an immediate annuity starts payments within a short period, while a deferred annuity allows funds to grow over time, with payments beginning at a later date.

Addressing Specific Financial Objectives

Annuities are structured to address several common financial planning goals, providing distinct mechanisms to help individuals achieve their objectives. One primary objective annuities can address is the need for guaranteed lifetime income, which helps mitigate longevity risk—the concern of outliving one’s savings. An annuity can convert a portion of retirement savings into a predictable income stream that lasts for the annuitant’s entire life, regardless of how long they live.

Another objective annuities can help achieve is tax-deferred growth for savings. Earnings within a deferred annuity are not taxed until they are withdrawn, allowing the money to grow more rapidly through compounding. When distributions begin, the taxable portion is taxed as ordinary income, not capital gains. The IRS applies a “last in, first out” (LIFO) rule, meaning earnings are considered withdrawn first and are subject to income tax. If withdrawals occur before age 59½, a 10% additional federal tax penalty may apply to the taxable portion.

Annuities can also contribute to capital preservation by offering protection for the principal invested. While variable annuities involve market risk, other types can provide stability and help protect against market downturns. Certain annuities facilitate legacy planning by allowing the annuitant to designate beneficiaries who will receive a death benefit. This death benefit can bypass the probate process, simplifying the transfer of assets to heirs.

Annuities can also supplement other retirement savings vehicles by offering a different type of income stream or growth opportunity. They can be particularly useful for individuals who have maximized contributions to traditional tax-advantaged accounts and seek additional avenues for tax-deferred savings without annual contribution limits. This allows for diversification beyond typical investment portfolios, providing a complementary layer of financial security for retirement.

Key Factors for Consideration

When determining if an annuity is a suitable option, individuals should evaluate their personal financial circumstances and long-term objectives. Retirement readiness and age are significant factors; annuities are considered by individuals nearing or already in retirement who are seeking a stable income stream. The older an annuitant is when payments begin, the higher the individual payments tend to be, as the payout period is expected to be shorter.

The status of existing retirement savings is another important consideration. Annuities are evaluated after other tax-advantaged retirement accounts have been fully utilized. This approach ensures that individuals first maximize contributions to accounts that offer greater liquidity and potentially lower fees. Annuities involve surrender charges if funds are withdrawn prematurely during an initial period, making them less liquid than other savings options. These charges can be substantial.

An individual’s risk tolerance also plays a role in annuity suitability. Those with a low tolerance for investment risk or a strong desire for predictable income may find certain annuity types appealing due to their guaranteed returns and income streams. The desire for predictable income is a primary driver for considering annuities, as they can provide a consistent financial inflow, similar to a pension, for a specified period or for life. This predictability can be valuable for budgeting and managing expenses in retirement.

Annuities are long-term financial products, and a long-term horizon is essential for purchasers. Funds committed to an annuity are intended for future income, and the illiquidity associated with early withdrawal penalties means they are not suitable for those who might need immediate access to their money. A strong financial situation, including sufficient liquid assets for emergencies, is important before committing funds to an annuity. Ensuring an adequate emergency fund and other accessible savings helps maintain financial flexibility and prevents the need for costly early withdrawals from the annuity.