A retirement annuity is a basic annuity where you pay into a contract for a fixed period of time and receive an income in return, often for life. Retirement annuities provide predictable income, giving people financial security and peace of mind. Here’s how retirement annuities work and how to decide if they might be right for you.
For help deciding whether a retirement annuity is right for you, consider working with a financial advisor.
What is a retirement annuity?
A retirement annuity is a financial product that provides a guaranteed income stream during retirement. You can purchase a retirement annuity either as a lump sum or by making premium payments over time. You can buy a retirement annuity from an insurance company. You can use a retirement annuity in conjunction with other retirement savings vehicles, such as 401(k)s or IRAs, to help ensure a stable and secure financial future.
When you retire, these annuities provide you with income for a specified period of time, or in some cases, for life. Pension annuities can be fixed or variable. Retirement annuities can be purchased from insurance companies and are often used in conjunction with other retirement savings vehicles, such as 401(k)s or IRAs, to help ensure a stable and secure financial future.
Types of pension annuities
There are many types of retirement annuities. The best choice for you will depend on your finances and retirement goals. Examples of common retirement annuities include:
Defined Benefit AnnuitiesThese are also known as retirement annuities and are sometimes offered by employers. Defined benefit annuities provide a guaranteed income stream for life. The amount of the benefit depends on a formula that takes into account your length of service and salary history.
Immediate annuitiesYou can buy an annuity outright with a one-time payment. After that, you start receiving payments immediately. Payments continue for your lifetime or for a specified period of time.
Deferred annuitiesYou can buy a deferred annuity for a one-time payment, but payments don’t start until a set date in the future. This type of annuity allows you to accumulate tax-deferred funds while providing a guaranteed income stream in retirement.
Fixed annuitiesFixed annuities provide a guaranteed rate of return on your investment regardless of market fluctuations. The income stream provided is also guaranteed and will remain the same throughout the life of the annuity.
Variable annuitiesVariable annuities allow you to invest in different investments. These include things like mutual funds, stocks, and bonds. Investment returns and the income stream provided are not guaranteed and will vary depending on the performance of the underlying investments.
Benefits of retirement annuities
Pension annuities have several advantages for retirees. As already discussed, their biggest advantage is that they provide a guaranteed income stream that can last until the end of the retiree’s life. This can make retirement planning easier. Another potential advantage is tax advantages, as retirement annuities can provide tax-free growth.
Another advantage of retirement annuities is that they are usually professionally managed. This eases your burden as a retiree. In addition, annuity managers typically have the experience and resources to manage the underlying investments and ensure a steady stream of income for retirees.
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Risks and Limitations of Retirement Annuities
When used correctly, annuities can give you a sense of greater financial security. However, they may still have some risks and limitations that you should keep in mind. The biggest risk is their limited liquidity. For example, if you pay premiums for a deferred annuity, that money is usually not available until you start receiving benefit payments. Sometimes there is a grace period when you can withdraw some funds, but that period is usually limited and early withdrawals may be subject to penalties and fees.
Another potential problem with retirement annuities is their fees. For example, there may be management fees, administrative fees and possible surrender charges. There may also be investment risk. Again, while annuities are often seen as a safety net of sorts, the reality is that some are safer than others. Although some annuities offer a fixed return, others are linked to an underlying investment such as stocks, bonds or mutual funds. In other words, investment risk may be involved and investment returns may fluctuate based on market conditions.
Taxes on pension annuities
Retirees should be aware of the tax implications of retirement annuities. The first point is that while annuity balances grow tax-free, distributions are taxed as ordinary income. This may exceed the capital gains rate. However, you can purchase the annuity with after-tax dollars, such as through a Roth IRA. In this case, the payments may be at least partially tax-free. This includes the portion of the payout that represents a return on your initial investment. Any portion of the payment that represents income may be taxed as ordinary income.
Complexity of annuities
Retirees should be aware that calculating retirement annuity fees can be complicated and different annuities may have different fee structures. Some annuities have a flat fee that is deducted from your account balance each year, while others have fees that are based on a percentage of your account value. Some annuities may also have additional fees for optional riders, such as guaranteed income or long-term care benefits. However, the specific payments you will receive may vary from one annuity to another.
For example, there may be administrative fees, investment management fees and surrender charges. There may also be a charge called mortality and expense (M&E) charges that cover the insurance company’s costs of providing death benefits. M&E fees typically range from 1% to 1.5% of the annual account value. It’s important to carefully review the fees associated with any annuity you’re considering and understand how they will affect your investment returns over time. A financial advisor can help you compare different annuity options and assess the costs and benefits of each.
How to buy a retirement annuity?
Buying a retirement annuity can be a complicated process, and you should carefully evaluate your options and retirement goals before making a decision. You’ll also need to decide how much retirement income you’ll need, as this will be a key factor in the annuity you’ll want to buy. After answering this question, evaluate the retirement annuities offered by online brokers and insurance providers. Carefully evaluate each option and choose the one that best fits your financial needs and retirement goals.
You should also work with a financial advisor who can provide guidance and advice on various retirement annuity products. They can help you evaluate your options and choose the product that best suits your individual needs.
Also, make sure you understand the fine print. Pension annuity products can have complex terms and conditions and it is important to read the fine print carefully before making a purchase decision. This may include being aware of surrender charges, income payment terms and any other restrictions or limitations associated with the annuity product.
Pension annuities provide a guaranteed income stream during retirement, which can last for life or for a fixed term. Some are purchased upfront for a one-time fee, while others are purchased at premiums over time. In addition to their guaranteed payouts, retirement annuities may have other benefits, such as tax benefits. However, they also have risks and limitations, such as lack of liquidity and high fees. Always review your options with a trusted financial advisor before making a decision.
Tips for Retirement
A financial advisor can guide you through major financial decisions, such as deciding your investment strategy. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches for free to determine which one is right for you. If you’re ready to find an advisor to help you reach your financial goals, get started now.
Deciding how to invest can be a challenge, especially when you don’t know how much your money will grow over time. SmartAsset’s investment calculator can help you estimate how much your money will grow to help you decide which type of investment is right for you.
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