An annuity is a financial product that provides regular payments over a set period of time. They are usually purchased in anticipation of retirement because they ensure your money will be repaid over a definite period of time and that you will gain interest while taxes on your funds are deferred.
Annuities, which are sold through insurance companies, usually come with a contract to protect you from suffering a loss.
There are several kinds of annuities, each with different payout options.
- You will need to decide between Fixed and Variable annuities. Fixed annuities are simple investments that are repaid at a later date. Within a variable annuity, you can choose stocks and bonds in which to invest. The performances of those securities determine your return on investment.
- A Lump Sum Annuity returns your money all at once, on one preset date
- A Period Certain Annuity sends you regular payments on a preset schedule
- A Life Annuity makes steady payments for the duration of your life. A similar investment is a Joint or Survivor Annuity, which pays off at regular intervals for the rest of you or a family member’s life.
You can purchase annuities through banks, mutual-fund companies and insurance providers.
Advantages Of Annuities
Compared to direct investment in the stock market, annuities are a relatively safe bet. Annuities guarantee you will get your investment back with accumulated interest and with deferred income taxes.
You will be charged a fee for purchasing an annuity, but small interest gains over a long period of time are meant to offset the fees. Annuities are not especially liquid because of the early withdrawal fines, but purchasing annuities is more hands-off than investing in the stock market, which can be volatile, especially when the economy is struggling.
Drawbacks Of Annuities
Annuities aren’t for everyone. In fact, the investments have some definite downsides to be considered before making a purchase.
Annuities often charge more fees than comparable long-term accounts. The average annual expense of carrying a variable annuity is about 2.44% of the product’s assets, according to SmartMoney.com. That number is more than 1% greater than the average annual fee on mutual funds.
If you invest in an annuity, don’t expect to take your money out anytime soon. Funds placed in an annuity are typically locked up for about five years. If you withdraw a portion of your funds early, you’ll pay fines as high as 6%. Withdrawing the funds within a long-term variable annuity before you turn 59 ½ years old can result in a 10% penalty.
An annuity is only as good as the insurance company that backs it. Experts recommend never placing a great portion of your savings in annuities with one company because of the customer liability that comes with annuities. In an interview with Forbes, Cuttone & Co. vice president Bernie McSherry said, “I would spread (annuities) among three or four providers at a minimum.” The economists interviewed by Forbes could not remember a case of an insurance company defaulting and costing its investors, saying action from the government saved customers’ investments.
One of the selling points of annuities is the tax-free interest they earn, meaning you will pay income tax on the money when you take it out, rather than when you originally earn it. Deferring the taxes is technically a solid deal, but assuming income taxes are not exorbitantly high, you would stand to make more by directly investing in the market.
A solid alternative to purchasing an annuity is buying U.S. Savings Bonds. For more info on these government-backed savings products, click here.