Wade Pfau, a professor of retirement income at The American College of Financial Services, recommends that annuities should account for no more than 20% to 40% of your retirement savings. For inflation protection and easier access to your money, the rest of your portfolio should be in market assets.

What are annuities?

Products that offer a consistent revenue source are annuities. In addition to being able to send money to your beneficiaries, they can offer tax advantages, customized payment schedules, and protection against losing your initial investment. Consumers frequently utilize annuities to provide lifetime income and aid in funding retirement.

An annuity contract, more specifically, is a legally enforceable written agreement between you and the insurance provider that issues the contract. Your longevity risk, or the risk of outliving your resources, is taken on by the insurance company under the terms of this contract. You are obligated to pay the contract’s premiums in return.

How do annuities work?

Annuities function by transforming a one-time payment into a steady stream of income that cannot be outlived. To meet their everyday necessities, many retirees require more than Social Security and investment funds.

Annuities are meant to provide this income either through an accumulation and annuitization process or, in the case of immediate annuities, with lifelong payments guaranteed by the insurance company that begins within a month of purchase – no accumulation phase is required.

When you acquire a deferred annuity, you basically pay the insurance provider a premium. Depending on the conditions of your contract, that initial investment will grow tax-deferred during the accumulation phase, which can last anywhere from ten to thirty years. You will begin receiving monthly payments after the annuitization, or distribution, phase begins — again, depending on the conditions of your contract.

The risk of a fallen market is transferred to the insurance firm by annuity contracts. This protects you, the annuity owner, from market risk as well as longevity risk, or the chance of outliving your money.

What are the 4 types of annuities?

The four main types of annuities available to suit your needs are immediate fixed, immediate variable, deferred fixed, and deferred variable annuities. These four choices are based on when you want to start receiving payments and how you want your annuity to develop, which are the two primary factors.

  1. Immediate annuities – a lifetime guaranteed option
  2. Deferred annuities – the tax-deferred option
  3. Fixed annuities – the lower risk option
  4. Variable annuities – the highest upside option

Where are premiums from fixed annuities invested?

Fixed annuity rates are determined by the yield generated by the life insurance company’s investment portfolio, which is generally comprised of high-quality corporate and government bonds. The insurance company is thereafter responsible for paying whatever rate the annuity contract guarantees.

Fixed annuities, unlike variable and indexed annuities, are not connected to the stock market or any other investment.

Your money instead increases at an interest rate set by the insurance company. A minimum guaranteed rate will be included in your fixed annuity contract. The annuity firm guarantees that the interest rate on your fixed annuity will not fall below that level. The principal investment is also guaranteed by the company.

Which two entities regulate variable annuities?

The Securities and Exchange Commission (SEC) regulates the selling of variable insurance products, while the SEC and FINRA govern the sale of variable annuities.

How are annuities taxed?

You don’t have to pay income taxes on your annuity until you take money out or start getting payments. If you bought the annuity with pre-tax funds, the money will be taxed as income when you withdraw it. Only if you purchased the annuity with money after taxes would you have to pay tax on the earnings. Annuities are advantageous because they can grow tax-deferred during the accumulation phase.

On the other hand, taxation applies to inherited annuity earnings. The payment structure and the beneficiary’s connection to the annuity owner—whether they are the surviving spouse or not—determine the amount that is taxed.

How can I avoid paying taxes on annuities?

You will not be taxed on your investment earnings if you do not withdraw them and maintain them in the annuity. If you do not withdraw your earnings from the annuity investments, they will be tax-deferred until you do.

If you inherit an annuity as the spouse of the annuitant, the same tax regulations apply. If you are not the annuitant’s spouse, your tax status is determined by how you get your payouts.

Consider a Roth 401(k) or Roth IRA as a funding source for your annuity to avoid paying taxes on it. Because Roth accounts are funded with after-tax earnings, you do not pay taxes on withdrawals.

Why are annuities bad investments?

Annuities, like all investments, are subject to risk. In general, they are illiquid investments that are susceptible to inflation. They can, however, be a highly useful part of a retirement plan if correctly structured, delivering a guaranteed source of income in a relatively low-risk, hands-off manner.

Here are some cons of annuities:

  • Limit your access to funds
  • Provide modest returns
  • Come with fees and surrender penalties
  • Can be complicated

To be sure, many investors, including retirees, should avoid purchasing an annuity. For consumers who need rapid access to their money or have substantial retirement income sources, the downsides of annuities far exceed the benefits.

Most importantly, annuities are not appropriate for an investment plan that seeks to achieve high rates of growth and capital gain. If you don’t have access to a 401(k) or an IRA, you might still use an annuity as a stand-alone retirement plan.

How much do annuities cost?

Varying forms of annuities have different costs. The higher the costs to the consumer, the more complicated the annuity is. Commissions and fees for sophisticated financial instruments are typically greater than for straightforward investments.

A fixed annuity will cost significantly less than a variable or indexed annuity. Because fixed annuities are straightforward, this is the case. They aren’t tied to stock portfolios or indexes like the S&P 500. They have simple regulations and pay at a rate that is established in the contract.

The same is true for adding riders or unique contract terms to tailor the annuity to your specific needs. These contract add-ons will increase your cost. Death benefits, minimum payouts, and long-term care insurance are examples of riders. Your yearly fees will increase with each rider you add and each adjustment you make to the main provisions of your annuity contract. These fees might range from 0.25 percent to 1% every year.

The average charge on a variable annuity is 2.3 percent of the contract value, although it can be higher.

How much do annuities pay?

If you bought a $100,000 annuity at age 65 and started receiving payments right away, you would receive around $479 each month for the rest of your life.

Income annuities (the sort outlined at the start of this post) have a wide range of monthly payouts, so working with a broker or consultant who works with numerous insurers and can show you the lowest rates for your age and type of payout is a good idea.

How do annuities work at death?

Annuity payments will stop after the annuity owner dies, depending on the contract terms. Annuities with a death benefit clause, on the other hand, allow the owner to name a beneficiary who will get the greater of the remaining money or a guaranteed minimum. This means that an annuity owned by a parent, spouse, or another family member might be left to a beneficiary.

Owners of annuities collaborate with insurance carriers to construct unique contracts that detail payout and beneficiary options. Insurance companies disburse any residual payments to beneficiaries in a lump amount or as a stream after an annuitant dies. If the owner dies, it’s critical to include a beneficiary in the annuity contract provisions so that the accumulated assets aren’t transferred to a financial institution.

Owners can tailor their annuity contract to help their loved ones in the same way they might set up a life insurance policy. The number of payments left after the owner dies is determined by the contract’s parameters, such as the type of annuity selected and the presence of a death benefit provision.