- Life & Money
- Financial Planning
- Your Retirement
- Daniel Schorn
- May 04, 2021
How Does an Annuity Work?
There’s so much to look forward to in retirement — namely, having time to do all the things that are truly important to you. But while it’s great to dream about all the fun things, it’s not uncommon for a concern to creep in: How will you pay for it?
According to a study by Northwestern Mutual, more than two-thirds of Americans are worried that they will outlive their retirement savings. And a more recent study by the American College of Financial Services found that the majority of respondents underestimated life expectancy. It’s a sign that so-called longevity risk is very real, as people misjudge how long they may live and how much money they will need in retirement.
The good news is that a financial plan can help prepare you for retirement risks like how long you might live and market volatility. One key way to prepare for these two risks is to add an annuity to your plan. An annuity can provide you with guaranteed payments that are unaffected by the markets and will last as long as you live. If you’re considering one, it’s natural to wonder: How does an annuity work?
In short, an annuity works with other parts of your financial plan, like investments or cash value life insurance, to significantly strengthen your overall retirement strategy.
The different types of annuities
Annuities are a financial product that you get from an insurance company, which can generate a guaranteed, regular income for life or help you save for retirement.
An annuity that will generate a guaranteed income for life is known as an income annuity, while annuities that help you save for retirement are known as accumulation annuities. Which type of annuity is right for you will depend on your situation.
If you’re approaching retirement, or are already retired, an income annuity will generate a guaranteed income stream, and take some of the risk of outliving your retirement savings off the table. With an income annuity, you typically use a portion of your savings to make a single payment or a series of payments. The annuity will then make regular payments back to you for the rest of your life.
The amount of your payments will depend on factors like how much you paid in, how long you’re expected to live and what features and guarantees you want to add to your annuity. There are two primary types of income annuities:
- Immediate income annuities, which start paying out a regular income soon after you have made a lump sum payment.
- Deferred income annuities, which start generating income after a set deferral or waiting period. If you’re several years from retirement, a deferred income annuity can be one way to guarantee an income stream once you have stopped working.
Some companies also offer portfolio income annuities, which offer the potential to grow over time based on the performance of the insurance company’s general account portfolio.
Income annuities sometimes get a bad rap because people believe an insurance company will keep their money if they die earlier than expected. But there are many ways to structure income annuities to ensure a payout for loved ones — usually so they can get back at least what you put into the annuity.
RELATED CONTENT: What is an annuity? Our guide to annuities can help you learn more about the unique role an annuity can play in your retirement planning.
Accumulation annuities are designed to help you save money for retirement. This can be an excellent option if you’re a long way from retirement and you don’t have a work retirement plan option, or you want to save more than you’re allowed through a 401(k) or IRA. With these annuities, you could someday withdraw your money, leave it to grow in the annuity or convert the value of your annuity into an income stream.
One great benefit of annuities is that they grow tax-deferred, meaning that you don’t pay any taxes on earnings until you take distributions through withdrawals or by converting your accumulation annuity into income payments. Over time, and through the power of compounding, your accumulation annuity grows undisturbed.
How your accumulation annuity grows depends on which type of accumulation annuity you choose:
- Fixed accumulation annuities grow at a guaranteed fixed rate, meaning that you will know exactly how much you’ll have once your annuity has hit certain milestones and you can begin withdrawing from it.
- Variable accumulation annuities grow at a variable rate, as the name suggests, because they have some market exposure. If you’re comfortable assuming some market risk, this type of annuity may be worth exploring.
Eventually, you could choose to convert your accumulation annuity into an income stream. But after a certain time period and after you reach the age of 59½, you could choose to withdraw from your accumulation annuity or surrender it (basically like closing an account and taking your money) without penalty. The IRS views annuities as retirement vehicles, which means that if you withdraw money before the age of 59½, you may face a 10 percent tax penalty. In addition, you may owe the company an early surrender charge depending on how long you have had your annuity.
Where you get your annuity matters
If you’re researching how an annuity works, you’ll notice the principles will be similar from company to company. But it’s important that you trust the company that you’re getting your annuity from. After all, you’re likely to have the annuity for decades. One way to check on the health of an insurer is to review its financial strength ratings from the nation’s top credit rating agencies. Northwestern Mutual has been around for more than 160 years and has attained the highest financial strength rating of any U.S. life insurer.
If you’d like to explore ways to strengthen your retirement plan or just make sure that the one you have is in good shape, you can connect with one of our trusted financial advisors.
Guarantees in an annuity are backed solely by the claims-paying ability of the issuer.
Income annuities (either immediate or deferred) have no cash value and once issued they can’t be terminated (surrendered). The original premium paid is not refundable and cannot be withdrawn. With any annuity, distributions may be subject to ordinary income tax and a 10 percent IRS penalty if taken prior to age 59 ½.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.
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