If you’re like a lot of people, you’re probably saving for retirement through a 401(k) at work or your own Individual Retirement Account (IRA). But you might be wondering if there are more predictable streams of income you could create for your retirement years — especially considering you may not be able to rely solely on Social Security or pensions in the future.
Annuities are one way to help create a guaranteed income stream. So what is an annuity? Essentially, it’s a contract between you and an insurance company, in which you pay the company regular premiums or a lump-sum payment in return for payments back to you over time.
INCOME ANNUITIES: IMMEDIATE VS. DEFERRED
Income annuities allow you to buy a stream of income for life. There are two different types of income annuities: immediate and deferred.
Immediate income annuities take a lump-sum payment from you with a promise to make payments back to you over either a fixed number of years or the remainder of your life. Immediate income annuities start paying out soon after you make your payment, which is why they are often considered by people who are close to or in retirement and looking for a more immediate, reliable source of income.
Deferred income annuities, by contrast, are designed for those who are looking to receive income at a later date. You can pay for them through either one lump-sum amount or regular premiums. They are often considered by people who still have a ways to go until retirement. For example, these may be a good option for someone in her mid 50s who has made large gains in the market and wants to use some of that money to lock in retirement income for the future.
The amount of the income payments you receive will depend on a number of factors, including but not limited to how much money you pay into the annuity, how long you’re expected to live once you start taking payments and when you buy the annuity. (If you buy a deferred income annuity at 55 and don’t take payments until 65, you may get a higher monthly payment than if you wait until you’re 65 to buy an annuity for the same amount.)
With an income annuity, typically you can’t take back the money you pay in. That’s a key difference from deferred annuities, which provide options to take out what you paid in.
DEFERRED ANNUITIES: FIXED VS. VARIABLE
Deferred annuities are designed to grow in value either at a fixed or variable rate. Think of them as long-term investments. That’s different from deferred income annuities, which don’t change in value after you buy them.
In a deferred fixed annuity, your earnings grow at a fixed interest rate, so your future payments will be, naturally, fixed. You may opt for a fixed annuity if you’re looking for a guaranteed interest rate and future payment amount.
In a deferred variable annuity, your payment is invested in one or more subaccounts, which are basically investment funds for you to choose from. The value of your annuity and future payments will therefore vary depending on the performance of the investments you go with, so variable annuities are typically better for people who are OK with taking on more risk.
Before deciding whether a deferred annuity might be right for you, it’s important to understand all the fine print, such as the fee structure and any penalties you may have to pay if you withdraw from your annuity early. If you withdraw money from a deferred annuity, you may owe taxes. In addition, if you take money out prior to age 59 ½, you may be subject to a 10 percent IRS penalty.
KEY TERMS TO KNOW
Annuitant: This person is also known as the “measuring life” because his or her life expectancy is used to help determine the terms of the annuity contract. Basically, the annuity will pay out based on how long the annuitant lives.
Payee: The payee will get payments from the annuity once it is annuitized (i.e., its value is converted into payments).
Owner: This person owns and controls the annuity contract. Typically, the owner, payee and the annuitant are the same person.
Accumulation phase: The amount of time your lump-sum or premium payments have to grow within a deferred annuity.
Annuitization: The point in time when the annuity’s value is converted into fixed or variable payments to the payee. Many annuities also allow you to add a second person as the annuitant, owner and payee — often referred to as “second to die.” Couples frequently use this option. It means that if, for example, the husband dies first, payments will continue until the wife also dies. Also, you don’t have to annuitize all of an annuity’s value at once. You can annuitize portions at different times.
Payout phase: The period of time over which you will be receiving your annuity payments.
Annuities are one way to help create a guaranteed income stream.
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.