What the &%#$ Are Annuities and Why Should You Care?
Annuities — you’ve heard the word. You may even have one. You may not realize exactly what you have, though. If the thought of understanding the different annuities makes you want to run for the hills, slow down. Annuities aren’t frightening or complicated. But, you need to know if and why annuities are a hot topic when it comes to retirement strategies.
What Is an Annuity?
Annuities are, in simple terms, insurance policies. In its basic form, an annuity is an account you contribute to as you work and pays you back monthly, quarterly, annually or in a lump sum when you retire. The amount of your payments is determined by how much and how long you contribute.
The two types of annuities are immediate and deferred. Immediate annuities, also called payout or income annuities are similar to a life insurance policy. Immediate annuities begin paying out immediately and are often the choice for people who have already retired. Deferred annuities accumulate contributions over time. The earlier a worker begins contributing, the larger the amount at retirement.
Either type of annuity can be fixed or variable within specific parameters. Fixed annuities pay guaranteed interest rates, which many people choose because they are a known retirement income stream. Variable annuities allow you to select investments where payoff is determined by investment performance. Annuities may also be a combination of fixed and variable.
What About Tax Breaks?
The money you invest into an annuity is tax-deferred. When you receive payouts, the money you contributed is not taxed, but annuity earnings are. In fact, tax deferment is one of the biggest advantages of contributing to an annuity.
Are Annuities Perfect?
As with any investment, carefully consider the fine print before signing up for an annuity. Most annuities are sold by brokers or salespeople who collect a commission, sometimes as high as 10 percent. High annual fees, particularly if you invest in a variable annuity, are also the norm. Insurance charges, management fees and insurance rider fees can take a big bite of your earnings. Not all annuities have high costs, however. Some firms sell annuities directly and cut out the insurance agent. To determine if a specific annuity is right for you, use a deferred annuities calculator to get a clearer picture of related fees and costs.
Another risk with annuities is that you contribute to a fund now expecting to be paid later, perhaps years later. If the insurance company you invest with goes out of business, you could lose your money.
Look for these insurer qualifications before investing in an annuity with an insurance firm:
- Check the firm’s credit rating with Moody’s, Standard & Poor’s and A.M. Best.
- Only use insurers that have an A+ rating from A.M. Best.
- Only use insurers that have AA- or higher grades from Moody’s and S&P.
- Ask your agent for the firm’s ratings or, better yet, look online.
Some states have guaranty funds that protect residents when insurance companies fail, but coverage varies from state to state and is limited in scope.
An annuity’s tax-free growth is appealing, but make sure you understand the fees, taxes and costs that impact your payout.