Annuities: What They Are and How They Work
Annuities are financial instruments that can assist provide a reliable source of income during retirement. However, an annuity is a complicated beast. Here’s a rundown of how annuities work, their benefits and drawbacks, and how they compare to IRAs.
What is an annuity?
An annuity is a long-term financial contract that guarantees you a steady stream of payments in exchange for a one-time investment. Annuities can aid with retirement income, estate planning, and tax avoidance.
The following are three compelling reasons to purchase an annuity:
Retirement income: You may require more income in retirement than Social Security. An annuity might help you avoid outliving your investments by providing a consistent income.
Annuities can give income to your beneficiaries if you die, and they can do so without having to go through probate in some situations.
Tax deferral: Investment profits in an annuity are not taxed until the money is withdrawn.
How much does a $100,000 annuity pay per month?
The size of your annuity payment is determined by several factors, including the amount you invest, the length of time you receive payments, and the amount your investment increases before you begin receiving payments.
The longer you wait for dividends, the more time your investment has to grow, and the higher your rewards may be.
In general, the longer you wait for payments, the smaller each check becomes.
Inflation may make what appears to be a large sum of money now appear to be a little sum later. A $1,000 monthly payment today will most likely go further than it will in 15 years.
How do annuities work?
Annuities can be complex, but here’s an overview of some characteristics to know.
The annuity life cycle
Annuity investments are usually divided into two segments.
- Accumulation. You make a one-time payment or a series of payments to the annuity supplier. The type of annuity you choose determines whether and how that money is invested while you wait to start receiving payments. This period could be brief or linger for decades.
- Annuitization. When you start receiving checks, you’ve entered the payout phase. You can choose to receive a lump-sum payment, but most customers prefer to receive a monthly payment.
Annuities come in a variety of shapes and sizes. Here are a few of the most common.
An annuity that starts paying out immediately away is known as an immediate annuity.
An annuity that pays out later is known as a deferred annuity. Because your money has more time to accumulate investment gains, you may receive larger dividends this way.
Annuity with a fixed rate of return: You pay a premium that is invested at a fixed rate of return. A guaranteed rate of return is used to grow the investment.
Variable annuity: An annuity that allows you to invest your premium in a variety of ways, including mutual funds and bond funds.
The annuity may provide a guaranteed minimum return and/or a maximum level of growth, depending on the provider.
This implies that your investment returns or payments may never go below a specified threshold (or go above a certain level). You could earn more money, but you’ll also be taking on more danger.
Equity-indexed annuity: In this type of annuity, the growth is based on a stock index, such as the S&P 500, and you are guaranteed minimum payments (they also may be capped). You could earn more money, but you’ll also be taking on more danger.
Riders: Adding riders to an annuity allows you to personalize it. Riders are add-on features that are available as an option. They differ depending on the issuer. Living benefits, which guarantee increases in your payouts at a specific time, and death benefits, which have the annuity cover your burial costs or pay a beneficiary, are two examples.
Annuities are tax-deferred investments, which means you only pay taxes on the income and/or earnings in the account when you withdraw funds.
When you buy an annuity using pre-tax dollars, such as from your 401(k) or IRA, the payments you get later are taxed at standard income tax rates (not capital gains rates, which are usually lower). Qualified annuities are annuities that are funded with pre-tax funds.
The income from an annuity purchased through a Roth IRA or Roth 401(k) may be tax-free.
If you buy an annuity with money that has already been taxed, you will normally only be taxed on the portion of the account that is gains or earnings when you withdraw money from it.
Can you lose your money in an annuity?
Yes. All investments come with some level of risk. The following are the two main dangers associated with annuities:
Market risk occurs when the value of your annuity’s investments declines, leaving you with a smaller pool of money and, as a result, smaller payouts in the future.
Issuer risk refers to the possibility that the issuer will not be able to pay out on your annuity.
Is an annuity a good investment?
Guaranteed payments are appealing if you plan to pay a major fixed expense in retirement, such as a mortgage, or if you are concerned about running out of money as you age.
- If you’ve already maxed out your contributions to other tax-deferred accounts like 401(k)s and IRAs, annuities can be a good way to enter into a tax-deferred investment.
- You’ll receive a predictable payment.
- Your annuity can be tailored to your preferences. You can select between an annuity that pays until you die or until both you and your spouse die.
- You have the option of purchasing an annuity with a death benefit, which allows you to choose dependents to collect any unpaid money.
- Over time, inflation can diminish the purchasing power of a fixed payout amount.
- In annuity investments, you may have a limited (or no) say.
- If your investment returns surpass the cap, you may receive a fixed or capped return, in which case the insurance takes the difference.
- Fees are higher than those charged by an IRA, and there are potential “surrender charges” if you cancel your insurance.
Keep in mind the costs that are frequently linked with annuities.
Surrender charges have been filed. You’ll almost certainly have to pay a surrender charge if you take money out of an annuity before the agreed-upon date. Surrender charges are usually assessed for a number of years after you purchase an annuity.
Expense risk fees and mortality. This usually amounts to roughly 1.25 percent of your account per year and compensates the annuity issuer for the risk it assumes under the contract; a portion of it may also go to the individual who sold you the annuity.
Fees for administration. It’s possible that you’ll be charged for record-keeping or other administrative costs.
Expenses incurred by the underlying fund. Fees and expenses for the underlying mutual funds in which your account is invested are normally paid by you.
Other characteristics. Special features, such as a guaranteed minimum income benefit or long-term care insurance, may need additional payments. You may also have to pay initial sales charges, which are fees that you must pay when you purchase the product, as well as fees for transferring funds from one investment option to another and fees for other actions.
Penalties for failure to pay taxes. If you take money out of an annuity before you reach the age of 59 12, you may be subject to a 10% tax penalty.
Annuities vs. IRAs
Annuities are just one of many ways to save for retirement. However, as previously said, they have their own set of advantages and disadvantages when compared to other popular vehicles such as IRAs. In certain critical areas, annuities compare well to typical individual retirement funds.
|Max annual contribution||None||$6,000 ($7,000 if age 50 or older)|
|Contributions tax-deductible?||No||Yes, if you meet income and other requirements|
|Ability to control how money is invested?||Yes, but can be limited||Yes|
|Can you lose money?||Yes||Yes|
|Early withdrawal penalty||Surrender fee based on contract, plus withdrawals before age 59 ½ may incur 10% tax penalty.||Withdrawals before age 59 ½ may incur 10% tax penalty (certain exceptions exist).|
What Are My Options for Selling My Payments?
You can sell the entire value of the annuity, a portion of the overall value for a lump amount, or a specific percentage of a specific number of installments once you’ve determined how much money you need.
Option 1: Sell My Annuity in Its Entirety
The asset is liquidated when you sell your annuity contract for its full value. This means you won’t have to pay any more money in the future. You will, however, have access to the entire money agreed upon with the buyer.
Option 2: Sell Some of My Future Annuity Payments in a Partial Sale
If you sell only a portion of your payments, you’ll continue to get regular payments and keep the tax advantages. You can sell some payments in exchange for a lump sum if you need money right away.
You can, for example, sell the first four years of your annuity payments for a lump sum. Periodic payments will continue after the four years have elapsed.
Option 3: Sell a Dollar Amount of My Annuity Payments for a Lump Sum
A lump-sum sale, like a partial sale, allows annuity owners to sell a portion of their payments in return for a lump sum. This means they’ll get a certain amount of money, which will be withheld from their annuity or structured settlement payments in the future.
How Will I Benefit From Selling My Annuity?
If your needs change, selling your annuity may be a good choice for you to gain liquid cash and financial flexibility.
Direct access to your assets can help you pay off debt, put a down payment on a new house, repair a broken vehicle, or take care of any other pressing financial needs. Having the freedom to use your money, regardless of why you’re selling, can help relieve financial stress.
It may also be less expensive to sell all or part of your future annuity income than to take a 401(k) loan or IRA withdrawal. Make sure to discuss your cash flow options with your financial advisor.
How Much Will I Receive for Selling Annuity Payments?
An annuity is a business transaction. Factoring companies want to make money off their purchases. This means you’ll be offered less than your annuity’s total value.
Account for the Discount Rate
A discount rate is the gap between the value of your annuity and the amount you’ll get in cash. The typical discount rate, according to various studies, ranges from 9% to 15%. It’s not uncommon to come across even higher percentages.
The savings is effectively a tradeoff for being able to access your money right away. It can also be used to offset administrative costs and lost revenue for the purchasing firm.