When you’re building a financial plan and preparing for retirement, annuities are likely to be one of many considerations. One question people frequently ask: Is an annuity an investment or an insurance policy? To be clear: Annuities are not investments, they are long-term policy contracts between you and an insurance company. However, some annuities have investment-like qualities, which is what can lead to some confusion.
Typically, annuities that have investment-like characteristics are used when you’re saving for retirement. Annuities that are like insurance policies are used to provide guaranteed income that you can’t outlive in retirement. Here’s what you need to know about both.
Some annuities have investment-like qualities
When saving for retirement, many people invest in funds that might hold stocks or bonds through accounts like a 401(k) or Individual Retirement Account (IRA). Accumulation annuities are another long-term savings option. These annuities typically offer either fixed (guaranteed) growth or variable performance. With a fixed annuity, your annuity will grow at a fixed rate over time. A variable annuity allows you to invest the funds you contribute into sub-accounts, which can be tied to market-based investments that go up and down in value.
As accumulation annuities are long-term retirement savings vehicles, there may be restrictions on your ability to take your money out shortly after you buy them. Because they get favorable tax treatment, the IRS may levy penalties and taxes if you withdraw your money too soon, similar to how a traditional 401(k) or IRA works. Additionally, the company that sells you the annuity may have a surrender charge for taking money out prior to a certain time, similar to the way a bank charges you if you take money out of a CD too soon.
While accumulation annuities are not investments, they do share a similar purpose: helping you save for retirement in a tax-efficient way, with a range of options based on your risk tolerance. If you’re looking to save for retirement and like the idea of lifetime income later, accumulation annuities could be a great fit in your retirement savings strategy.
Annuities that are like insurance
When in retirement, you’ll probably want to lock in some income that you can never outlive to cover basic living expenses. Annuities that are like insurance can help you do that. For an upfront contribution, income annuities will guarantee regular payments back to you for as long as you live. The insurance aspect is that you can’t outlive your money – similar to how life insurance helps mitigate the financial risk of passing away prematurely, income annuities mitigate the risk of outliving your assets.
In addition, most income annuities that offer fixed payments aren’t affected by the markets. That can make an income annuity a very safe and reliable component of your retirement income plan. Often, people will use a portion of their retirement savings to buy an income annuity that will pay enough to cover essential expenses like food, taxes and utilities.
Because income annuities provide lifetime income to help ensure you’ll be able to cover your basic living expenses, you can’t withdraw the premium that you pay in. That leads to a common criticism of annuities — that you lose money if you die too soon. While this can be the case, many income annuities offer optional benefits that ensure you or your beneficiaries will get a certain number of payments, or get at least as much back in income as you paid in.
What is an individual retirement annuity?
You’ve probably heard of an individual retirement account. This account lets you save for retirement in a tax-advantaged way. It’s typical for people to use investments within an IRA. But the truth is that you can hold other types of financial tools in an IRA, including an annuity. Annuities that are used to fund IRA accounts are sometimes called individual retirement annuities.
If an annuity is used to fund an IRA, all IRA contribution and tax rules apply; however, it’s important to note that if an annuity is used to fund an IRA account, there is no additional tax benefit provided by the annuity.
Comparing annuities to life insurance
Income annuities are a type of insurance product that’s based on your life expectancy. That’s because they are typically designed to make payments to you for the rest of your life, no matter how long you live. Whereas life insurance protects your family in the case that you die too soon, income annuities protect you financially in a situation where you live a very long time.
If you’d like to learn more about the different types of annuities and how they might fit into your financial plan, connect with a financial advisor who can answer your questions.
Guarantees in an annuity are backed solely by the claims-paying ability of the issuer, but do not apply to the investment sub-accounts in a variable annuity which are subject to market risk. Withdrawals from annuities may be subject to ordinary income tax, a 10 percent IRS penalty if taken before age 59 ½, and contractual withdrawal charges. Income annuities have no cash value. Once issued, this annuity cannot be terminated (surrendered), and the premium paid for the annuity is not refundable and cannot be withdrawn.
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