Retirement Annuities: Your Future Financial Freedom

Retirement annuities are insurance products that provide a guaranteed income stream for retirees. They are often funded years in advance, either through a lump sum or a series of regular payments, and can offer fixed or variable cash flows. While annuities are perceived as having large upfront costs and early withdrawal penalties, they can serve as a secure income stream in retirement.

Annuities can be a good investment option for those seeking a stable, guaranteed income for life, looking to save more for retirement in a tax-deferred investment vehicle, or wanting asset protection with growth potential. They offer tax-deferred growth, guaranteed rates of return, and survivor benefits.

However, annuities also have some drawbacks, including high fees and commissions, lack of liquidity, and the possibility of an insurer defaulting. It's important to carefully consider the pros and cons before investing in retirement annuities.

Peace of mind: guaranteed income for life

One of the biggest worries for retirees is outliving their savings. Retirement annuities can help ease these concerns by providing a guaranteed income for life.

Retirement annuities are a contract between an investor and an insurance company. The investor contributes a sum of money, either upfront or in payments over time, and the insurer promises to pay them a regular income in return. This income can be structured to pay out over a few years or for the rest of the investor's life.

Annuities can be a good option for those who want peace of mind and to ensure they don't outlive their savings. They can also help to supplement Social Security benefits and retirement assets by providing income that is sheltered from economic volatility.

There are two main types of annuities: fixed and variable. In a fixed annuity, the insurance company pays a specified rate of return on the investor's money, providing stable and reliable income. Variable annuities, on the other hand, invest the money in a portfolio of mutual funds chosen by the investor, with the return fluctuating based on their performance.

While annuities can provide peace of mind and guaranteed income, it's important to consider the potential downsides, such as high fees, early withdrawal penalties, and complex contracts. Annuities are not always the best option for younger investors or those who need immediate access to a large sum of money. It's recommended to consult a financial advisor to determine if annuities are the right choice for your financial goals and risk tolerance.

Tax benefits: tax-deferred status

One of the most attractive features of retirement annuities is their tax-deferred status. This means that money invested in an annuity grows tax-free until it is withdrawn or when payments begin. This can be a significant advantage for those who want to delay paying taxes on their retirement savings until they actually start receiving the income.

The tax-deferred status of retirement annuities can also help reduce your Social Security taxes. By leaving the money in the annuity and delaying withdrawals, you lower your taxable income, which in turn reduces the amount of Social Security taxes you have to pay. This can be especially beneficial for those who are still working and receiving a salary, as it can lower your overall tax burden.

Another tax advantage of retirement annuities is that only the earnings are taxed when you make withdrawals. The amount you contributed to the annuity is not taxed, as it was money you already earned and paid taxes on. This is similar to the way retirement accounts like 401(k)s and traditional IRAs are taxed. However, it's important to note that the earnings are taxed at your regular income tax rate, not the lower capital gains rate.

Retirement annuities also offer the flexibility to choose when you want to start receiving payments. With immediate annuities, you start receiving payments right away, while deferred annuities allow you to postpone payments until a later date. This flexibility can be beneficial for those who want to time their annuity payments with other sources of retirement income or life events.

It's important to note that while retirement annuities offer tax advantages, there are also potential tax penalties. For example, if you withdraw money from an annuity before the age of 59½, you may be subject to an additional 10% tax on early distributions, unless you meet certain exceptions. Additionally, when you do start receiving payments, the taxes owed on the earnings can be higher than the capital gains tax rate, depending on your tax bracket.

Customisable: adaptable to your needs

Retirement annuities can be customised to fit your needs. For example, you can choose to have a death benefit provision that ensures your heirs will receive something when you die. You can also add a guaranteed minimum income benefit rider, which promises a certain payout regardless of how well the mutual funds in a variable annuity perform. A joint and survivor annuity can also be added to provide continued income for a surviving spouse.

Annuities can also be fixed or variable. In a fixed annuity, the insurance company pays a specified rate of return on the investor’s money. In a variable annuity, the insurer invests the money in a portfolio of mutual funds, or “subaccounts,” chosen by the investor, and the return will fluctuate based on their performance.

You can also choose between an immediate annuity, where income begins almost right away, and a deferred annuity, where income starts at some point in the future, usually during retirement. The dollar amount of the income payments is determined by factors such as the balance in the account and the age of the investor.

Inflation hedge: maintain purchasing power

Inflation is a concern for retirees as it erodes purchasing power over time. As the cost of goods and services increases, retirees on a fixed income may find their purchasing power reduced, and goods and services that were once affordable may now be out of reach.

Annuities can be used as a hedge against inflation, helping retirees maintain their purchasing power. Variable annuities, for instance, can be used to maintain purchasing power if investment decisions boost periodic payments to cover inflation.

There are a few different types of annuities that can be used to mitigate the risk of inflation:

• Deferred annuities with guaranteed lifetime income: These annuities can provide lifetime income to cover essential expenses, freeing up dollars to invest as a hedge against inflation. Many annuity providers offer guaranteed withdrawal benefits for an additional cost.
• Income annuities: Purchasing single-premium annuities (SPIAs) and/or deferred income annuities (DIAs) can help mitigate inflation risk. Features such as inflation protection can ease anxiety about purchasing power by increasing the retiree's payment by a stated percentage over the term of the contract.
• Indexed annuities: Indexed annuities follow indexes made available by insurance companies, providing higher returns than CDs or savings accounts. Some companies offer guaranteed withdrawal benefits for an additional cost, allowing other assets to be invested for growth as an inflation hedge.
• Inflation-adjusted annuities: Some annuities are inflation-adjusted, meaning their payment amounts will increase according to increases in the CPI. Most inflation-adjusted annuities have a limit on how much the amount can increase each year, known as a cap.

Additionally, the concept of "laddering" can be applied to annuities to help combat inflation. This involves buying multiple annuities and timing them so that each of their guaranteed income streams begins at a different date, stretched over several years. As the annuitant ages and inflation grows, new streams of income will continuously be received to help stay ahead of rising costs.

Flexible: transfer money, hold inside or outside a retirement plan

Retirement annuities are a flexible option for those saving for retirement. You can transfer money from one annuity to another, even if they are with different companies, through a 1035 exchange. This method allows you to avoid paying taxes on your annuity earnings.

You can also hold an annuity inside or outside a retirement plan. For example, you can hold an annuity in a retirement plan such as a 401(k) or an individual retirement account (IRA), or you can hold it outside a retirement plan. This flexibility means that you can choose the option that best suits your financial goals and circumstances.

Additionally, you can transfer an IRA or 401(k) plan into an annuity tax-free, providing a steady retirement income stream. This can be done through a direct transfer or an indirect qualifying withdrawal. A direct transfer is a more straightforward process, handled primarily by financial institutions, and helps to avoid taxes and penalties. With a qualifying withdrawal, you take possession of the liquidated retirement funds and then roll the gross amount into an annuity within 60 days to avoid tax complications.

It's important to note that there may be fees associated with transferring annuities, such as surrender fees, and it's essential to carefully review the terms and conditions before making any decisions.

Frequently asked questions