The Pros and Cons of Annuities

Making sure you have enough money for retirement requires getting strategic. There are a lot of moving parts: what you have saved in retirement accounts, how much you’ll be able to collect from Social Security or a pension, other investments you hold, and the various sources of income you could tap after you’re done receiving a steady paycheck.  

One potential piece to this puzzle: annuities. So what are annuities? Annuities come in many forms, but generally they fall into two main categories: accumulation annuities, which help you save money in the years leading up to retirement, and income annuities, which provide guaranteed income in retirement.  

It’s important to know the pros and cons of annuities before deciding whether they make sense for your situation. We’ve outlined them below to help you get started.  

The pros of annuities 

You have options depending on your timeline. 

If retirement is still years away, you could opt for an accumulation annuity, which allows you to save money tax-deferred, and can be used to provide income when retirement arrives. If you’re nearing retirement or just about to retire, you may want to consider an income annuity, which will start making income payments to you a few months or a few years after you purchase it from the insurance company (exactly when you want your income to start is entirely up to you).  

You have options depending on your comfort with risk. 

Accumulation annuities can be either fixed or variable. The money inside a fixed annuity grows at a fixed interest rate. But if you’re good with taking on more risk, you could opt for a variable annuity, which invests your money in investment funds known as subaccounts. If the subaccounts perform well, your retirement savings will grow. But just like with other investments, if your subaccounts perform poorly (perhaps even decline in value), your retirement savings could shrink. 

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. 

You can use qualified and non-qualified dollars. 

Qualified and non-qualified refer to the way money you earn in a given year is treated from a tax perspective. Qualified dollars “qualify” for special tax treatment, so those contributions are considered pre-tax (like the contributions you make into a 401(k) or an IRA). Non-qualified money refers to dollars you’ve already paid income tax on, so they are considered post-tax. 

You can put both qualified and non-qualified dollars into an annuity.

If you’re using non-qualified dollars, there is no contribution limit. If you’re purchasing an annuity with qualified dollars, you’ll be subject to an IRS limit on your contributions.  

Your money grows tax-deferred. 

It doesn’t matter if your contributions were qualified or non-qualified, your money will grow tax-deferred in an accumulation annuity. This means that your investment gains will compound more over time than if they were taxed along the way (assuming an identical earned interest rate). 

You can get guaranteed income for life. 

When you live off your savings in retirement, you take the risk that you could live too long or lose money in the market and eventually run out of money. Income annuities help protect against that by providing guaranteed payments either for a set amount of time or for the rest of your life — no matter how long you live. 

Ready to take the next step? A financial advisor can show you how all the pieces of your financial plan fit together. 

The cons of annuities 

You may pay higher fees for accumulation annuities than for some other types of investments. 

When compared with fees you pay for mutual funds, index funds or other investments, some accumulation annuities charge higher fees, often due to the optional benefits and guarantees they may provide. Carefully discuss these optional benefits and guarantees with a financial advisor to determine which ones are worth the cost.  

You may have to pay a surrender charge to withdraw money from an accumulation annuity. 

If you decide to withdraw your money in the first few years after purchasing an accumulation annuity, you may have to pay a surrender charge. After a certain number of years (usually five to ten), surrender charges will no longer apply. However, you may still have to pay taxes and penalties to the IRS if you withdraw your money before age 59 ½ from a qualified annuity. 

You may not be able to change your mind once you buy an income annuity. 

Income annuities provide guaranteed income for life, but are often nonrefundable, which means you can’t take your money back after you purchase them. Therefore, it’s important to not put all your eggs in one basket (ie, keep some money in savings accounts as well), and to consider your entire retirement picture when determining if an income annuity is a good fit for you. 

You may not get all your money back from an income annuity if you die early. 

When you purchase an income annuity, income payments often continue for as long as you live. If you die early, you may receive less in income than you initially paid to purchase the annuity. However, many income annuities offer a feature called a “period certain”, which guarantees that a certain number of payments will be made to you or your beneficiaries, even if you die early. Many income annuities also offer a “cash refund” option, which guarantees that a lump sum will be paid out to your beneficiaries when you pass away if you have received less in income than you paid for the annuity. 

Guarantees in an annuity are backed solely by the claims-paying ability of the issuer. 

The performance of variable funds and underlying investment options are not guaranteed and are subject to market risk, including loss of principal.  

Withdrawals from annuities may be subject to ordinary income tax, a 10% IRS penalty if taken before age 59½, and contractual withdrawal charges.