Annuities can serve a number of purposes — they can help you manage your money, serve as an additional investment vehicle, and most importantly, they can guarantee you an income stream when you need it.
There are many different types of annuities and contracts are customizable, so whether or not an annuity is a good addition to your financial plan depends on your personal situation and the specific type of contract you purchase.
What is an annuity & how does it work?
An annuity is a type of insurance contract that guarantees you a source of income — most often for life — in exchange for a series of payments, or a single lump-sum payment. Annuities are often used to prevent you from outliving your savings, or to otherwise supplement your investment strategy or retirement plan.
You fund your annuity and your principal grows during the accumulation phase. Eventually, you enter the payout phase — also called annuitization — which is when you begin receiving income payments from your annuity instead.
Annuities can be immediate or deferred, which means you can either start receiving income payments within a year, or several years in the future. You can choose when your annuitization phase begins based on when you need the income.
Learn more about immediate vs. deferred annuities
Is an annuity a good investment?
While most annuities don’t directly invest your money in the stock market — and therefore aren’t technically investments — they can serve a variety of purposes for your financial plan.
One of the biggest advantages of annuities is guaranteed income, explains Nadia Vanderhall, financial planner and founder of The Brands and Bands Strategy Group, a financial planning and education firm. Plus, “some annuities offer lifetime payouts. They can also offer tax advantages on your savings.”
Each type of annuity has slightly different features and different levels of investment risk, so whether an annuity is a good choice for you depends on the specific subtype and your financial situation. You should also consider your age, your retirement income goals, and your current finances when determining if an annuity is a fit, Vanderhall says. Here are a few of the most common types.
Learn more about how annuities work
Common types of annuities to choose from
Fixed annuities
Fixed annuities offer a guaranteed minimum rate of return and a guaranteed amount of income in the future. Fixed annuities are often compared to certificates of deposit (CDs), because you’re locking in an interest rate for a predetermined number of years.
However, unlike with CDs, you won’t have to pay taxes on the interest your annuity gains each year — you’ll only pay taxes when you start receiving income from your annuity.
Can you withdraw money from your annuity?
Indexed annuities
Indexed annuities allow your funds to grow based on the performance of a stock market index (for example, the S&P 500). Indexed annuities typically come with features that will both cap your gains and limit your losses up to a certain extent. This way, you’ll have higher earning potential than with fixed annuities, but you’ll have some safeguards against losses, too.
There are different types of indexed annuities that come with varying levels of investment risk, so be sure to check the terms of the specific contract you’re considering.
What is the impact of interest rate changes on your annuity?
Variable annuities
Variable annuities let you invest your funds in subaccounts, which gives you a more hands-on approach to your investments. Variable annuities don’t offer guaranteed returns, and the income you receive later on will depend on market performance. Since you’re exposed to more market volatility, variable annuities are considered securities and regulated by the SEC and FINRA. [1]
Learn more about the differences between fixed and variable annuities
What are the main benefits of annuities?
Annuities can complement your financial plan in a variety of different ways — whether that’s providing you an income stream later on or converting a lump sum into a manageable series of installments. Here are a few of the main benefits.
Annuities can provide a guaranteed income
One of the biggest benefits of annuities is that they can offer you an additional guaranteed income stream — either for a predetermined number of years, or for life. This can help you cover essential expenses and ensure that you have a source of income for the years you need it.
Annuities can help you manage your money
Annuities can help divide up your assets into a fixed income stream. Especially if you have a lump sum from a Roth IRA, 401(k) plan, or the sale of a home, an annuity can convert that lump sum into manageable payments.
Annuities can provide fixed, predictable returns
Certain types of annuities — mainly fixed annuities — provide a guaranteed minimum interest rate, so you know exactly how much your funds will earn. This can be beneficial if you’re looking for a low-risk additional investment vehicle.
Even if you don’t buy a fixed annuity, some insurers allow you to allocate a portion of your funds in a fixed subaccount, so you can have some guarantees that way, too.
Can you lose money in an annuity?
Annuities offer tax-deferred growth
One of the most significant benefits of annuities is tax-deferral. You won’t pay taxes on your annuity funds every year — you’ll only pay taxes on your earnings when you start to receive income from your contract.
If you fund your annuity with after-tax dollars (also called non-qualified funds), you’ll only pay taxes on the interest earned. If you fund your annuity with pre-tax dollars, like through a 401(k) plan (also called qualified funds), you’ll pay taxes on the principal and interest.
Just keep in mind that similar to other retirement accounts, you’ll pay a penalty fee for early withdrawals before age 59½. [2]
Do annuities affect financial aid and other benefits?
Some annuities don’t have contribution limits
Unlike other tax-deferred investment vehicles, some annuities don’t come with contribution limits per the IRS, which means you can fund them with however much you need. Some insurers set a maximum contribution limit, but it’s typically much higher than limits to 401(k) plan or IRA contributions.
Can annuities be used as a collateral for a loan?
Annuities are highly customizable
You can customize your annuity with riders or add-on features that fit your needs. You can typically either add living benefits, which affect or increase your income stream while you’re alive — or death benefits, which can impact how much money your beneficiaries receive when you’re gone.
You can use riders to help your income payments keep up with the cost of living, guarantee your beneficiaries a certain amount of money when you die, and more.
Learn more about retirement annuities
What are the main disadvantages of annuities?
While annuities can help in a variety of financial situations, they’re not for everyone. It’s important to be aware of all the stipulations and fees that come with your contract before you buy.
Contracts can be complicated
There are many different types of annuities and many features you can add that vary by insurer. Annuities can be difficult to understand without the help of an advisor, so it’s helpful to consult a professional before buying.
Annuities can charge high fees & commissions
Some annuities — especially indexed or variable annuities — can come with investment management fees, administrative fees, and commissions that can detract from your earnings. [3] It’s important to read your contract thoroughly before buying to have an understanding of the fees you’ll need to pay.
They offer limited or no liquidity
Once you put your funds in an annuity, they aren’t liquid — meaning you can’t access the money. “Your money’s locked in, and early withdrawals often come with penalties,” Vanderhall says.
Most types of deferred annuities have surrender periods during which you can’t withdraw funds without paying a penalty fee for the first few years you own your contract. For these reasons, it’s important to be confident you’re buying the right annuity for your situation from the start.
Annuities can offer limited investment opportunities
Typically, the main purpose of an annuity is to guarantee a future source of income, rather than to grow your money. For instance, fixed annuities offer lower returns on average when compared to other investment vehicles. On the other hand, variable annuities offer more growth potential but often don’t come with guaranteed minimum returns or guarantees on your principal.
If your main goal is market growth, you may want to consider other investment products.
Annuities don’t guarantee an inheritance for your heirs
Although annuities can guarantee you income for life, they may not help you support your beneficiaries after you’re gone. If this is a priority of yours, you’ll have to choose your payout schedule carefully.
Typically, you have a couple of options to choose from:
Life only annuities only pay out for the life of the annuitant — once the annuitant dies, payments stop. This is the most common type of payment schedule across all types of annuities.
Life with cash refund annuities also pay out for the life of the annuitant. But if the annuitant dies prematurely, the insurance company will pay the beneficiary the remaining value of the premiums paid into the annuity. For instance, if you contribute $500,000 from an IRA into an annuity and you pass away after receiving $100,000 in total payments, your beneficiary can claim the remaining $400,000.
Period certain annuities pay out in installments for a specific number of years, and then stop — regardless of whether the annuitant is alive or not. Common time periods are 10 to 20 years.
Life with period certain annuities pay out for the life of the annuitant, but with a guarantee that if the annuitant dies within a certain time frame (for instance, 10 years) the insurance company will pay out installments to the beneficiary for the remainder of the designated time frame.
Learn more about life only vs. period certain annuities
Who can benefit from annuities?
Annuities can benefit people in a number of situations, but here are a few common examples.
High earners
If you’re a high earner, annuities can help you diversify your investment portfolio, while also taking advantage of the features that come with many annuity contracts — like a guaranteed minimum rate or guaranteed payout period. Annuities also give you another way for your funds to grow tax-deferred.
Fixed annuities in particular can offer another safe investment, which could allow high earners to take on more investment risk in other accounts.
Retirees
If you’re retiring, annuities can convert your savings into an income stream and ensure that you won’t outlive your funds. Many people elect to convert their IRA or 401(k) balance into an annuity upon retirement to provide an income stream in addition to Social Security.
People who’ve received an unexpected windfall
If you’ve received a large sum of money from the sale of an asset, an inheritance, or even a lottery win, annuities can help you manage your money and convert it into an income stream. In this case, you might benefit from a single-premium immediate annuity (SPIA).
Alternatives to annuities
If you’ve done enough research to know that an annuity won’t solve for your specific needs, you can consider some different options. Vanderhall points out that IRAs and 401(k) plans “offer tax benefits and investment choices. You can choose a mix of stocks, bonds, and cash to grow your savings.”
If you’re considering this option, Vanderhall advises to determine the “cash” and “carry” when it comes to IRAs — “the cash is good if you need it…but the “carry” are the funds that would…grow the account value, like index funds and ETFs.”
Certificates of deposit (CDs) are also an option you could explore. “These are offered by banks and credit unions. They lock up your money for a set time, but offer a guaranteed interest rate,” Vanderhall says. “Even considering opening up a high-yield savings account (HYSA) could be another option to keep cash to grow until you need it.”
If you’re not sure which financial product is best for your specific situation, speaking with a financial planner can help.
How does an annuity fit into your overall retirement plan?
