You want a steady income stream during retirement — and an annuity may be just the ticket. But first, you need to understand annuities and their many choices. Basically, an annuity is a contract with an insurance company that promises a certain amount of money on a periodic basis for a specified time. Your contributions have tax advantages; investment earnings grow tax-free until you start withdrawals.
There are two varieties:
- With immediate annuities, you give the insurance company a lump-sum payment and start receiving payments right away. Payments can be a fixed or a variable amount, depending on the contract. Choose this type of annuity if you have available a large lump sum, like a substantial inheritance.
- Deferred annuities use tax-free compounding with guaranteed cash flow paid out in the future. You can purchase this type of annuity with a lump-sum payment, periodic contributions or a mix.
Other broad categories are fixed, indexed and variable annuities:
- Fixed annuities provide a predictable source of retirement income with relatively low risk. You receive a specific amount of money every month for the rest of your life or whatever period you choose — 5, 10 or 20 years. You have the security of a guaranteed rate of return, so make sure you’re dealing with a solid insurer with high grades from insurance credit rating agencies. The downside? You don’t glean the benefits of a fast-rising market, as you would with an index fund, for example. And if inflation heats up, an annuity can lose spending power.
- Indexed annuities combine the features of a fixed annuity with the possibility of additional investment growth if markets rise and your return is pegged to any rise in a relevant market index, such as the S&P 500.
- Variable annuities provide a return based on the performance of a portfolio of mutual funds that you select.
What’s the tax story?
What are the tax benefits of annuities? During the accumulation phase, your earnings grow tax-deferred. You pay taxes only when you start taking withdrawals. Withdrawals are taxed at the same rate as your income. If you’re funding your annuity through an individual retirement account or other tax-advantaged retirement plan — what’s called a qualified annuity — you may be entitled to a tax deduction for your contribution.
When the money comes out
Once you decide to start the distribution phase, your insurance company will calculate your periodic payment amount by using a mathematical model. The most common choice is to receive monthly payments for the rest of your life or for the rest of your spouse’s life as well.
There is something of a gamble with an annuity; if you live for a long time after you start taking distributions, you could receive a lot more money than you ever put into an annuity. But if you die soon after you purchase it, you won’t get your money’s worth. So, you may want to add another provision: a guaranteed number of payment years. If you and your spouse die before the period is over, the insurer will pay the remaining funds to your heirs.
This is just an introduction to a complex topic. Before buying an annuity, consult with an independent financial professional to see if an annuity is right for you —and if it is, what kind is best.