As of November 2021, only 15% of private industry workers had access to a defined benefit pension from their employer. Why is that disheartening? A pension guarantees a steady income once you retire.
Meanwhile, more options are being offered to workers to save for retirement. As of 2021, 81% of private-sector employees had access to employer-sponsored retirement plans, such as 401(k). Furthermore, studies show that employers are looking to enhance their defined contribution (DC) retirement plans in an effort to increase employee security, financial well-being, and retention.
In contrast, a Morgan Stanley at Work study found that 62% of employees cut back on short- and long-term savings contributions in the face of high inflation. To make matters worse, there is a great deal of uncertainty surrounding Social Security’s future. A Social Security Board report issued in 2021 predicted that the agency’s cash reserves would be exhausted by 2034 – one year sooner than their 2020 report anticipated.
Let’s be honest, though. A retirement plan only provides savings. The income they provide is not guaranteed. And that’s where annuities come into play.
With annuities, you can generate a steady and guaranteed income stream in retirement by accumulating earnings tax-deferred until you are ready to withdraw. Unfortunately, many people do not fully understand the options available during payouts. The following information will help you gain a better understanding of the topic.
How an Annuity Works
Annuities provide people with a steady cash flow during their retirement years, so they don’t have to worry about outliving their money. When retirement savings aren’t enough to live off of, some people buy annuities from an insurance company or a financial institution.
In other words, annuities are a good choice for those who want stable, guaranteed retirement income. However, for young people and those who need easy access to their money, annuities aren’t recommended because invested cash is illiquid and has withdrawal penalties.
There are several phases and periods in an annuity. They are referred to as:
- During the accumulation phase, annuities are funded, and payments begin. During this stage, your money grows tax-deferred.
- Once payments start, the annuitization phase starts.
There are usually two types of annuities: immediate and deferred. Before you buy an annuity, you should ask if you want regular income right away or in the future.
We’ll quickly go over each’s advantages and disadvantages to help you decide.
With deferred payments, your money grows over time. Annuities accumulate earnings tax-free until you start receiving payments like 401(k)s and IRAs. Keeping that amount up could lead to higher payments down the road. These are known as accumulation periods or accumulation phases in annuity terminology.
The name ‘immediate annuity’ says it all. Payments can start rolling in as soon as the buyer pays the insurance company.
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) regulate annuities. Agents and brokers who sell annuities need a life insurance license, and a securities license if they sell variable annuities. Typically, these agents and brokers get a commission based on the contract’s notional value.
Types of Annuities
“Just like there is all different type of pizza, there are also a variety of different annuities,” explains Due Founder and CEO John Rampton. “But, the three main types of annuities are fixed annuities, variable annuities, and indexed annuities.”
Be sure to research the different types of annuities, how they work, and the fees associated with them before selecting one. Additional flexibility may be available through riders alongside your annuity contract. As with pizza toppings, you’ll probably have to pay more for a rider.
“In general, a fixed annuity is easy to grasp since it’s the most straightforward,” John adds. A fixed interest rate is promised by the insurance company rather than being tied to market rates. For example, with a Due Fixed Annuity, you’ll get a 3% guaranteed interest rate on your money.
There are two types of fixed annuities.
- The fixed immediate annuity provides a fixed income stream over a specific period of time in exchange for a lump sum payment. The payment may last for the rest of your life, depending on the contract. It is also common for payments to begin immediately.
- In the same way as immediate fixed-income annuities, deferred annuities are affected by time. The income stream, however, is delayed in comparison to immediate annuities. The payments can take months to years to start after you buy your annuity. Since your annuity is accumulating interest, this is what’s called the accumulation period. Your income may increase in the future if you make extra payments during this period.
Variable annuities do not have as clear-cut rules as fixed annuities. As a matter of fact, you may even consider these to be investment products.
You can select a variety of investments with a variable annuity. Your contract’s value is determined by those sub-accounts. Its value may rise or fall based on the performance of your investments.
In most cases, investors invest in stocks, bonds, and money markets through mutual funds. There is also the possibility of combining these investments.
It is kind of like a hybrid between a fixed annuity and a variable annuity. Market drops are protected by index annuities, but rising markets are not.
How come? With an indexed annuity, you can receive guaranteed income. An index, such as the S&P 500, will determine another portion of your income, providing you with the opportunity to grow your investment.
Annuity Payout Options
Another thing to consider is how long the income stream will last. You can structure the payout schedule however you want. However, these are the most common payout options.
Single Life/Life Only
The single-life annuity, also called a straight-life annuity or life-only annuity, lets you get payments for life. With this annuity, there are no survivor benefits, as opposed to some other options that let you name beneficiaries or spouses.
In case you die before receiving your entire premium, the insurance company keeps the rest. By buying a period-certain annuity, you can reduce the chances of this happening.
In short, no matter how long you live, you will always receive a monthly payout. There is a downside, however. If you pass away relatively quickly, your beneficiaries will not be able to inherit anything.
Life Annuity with Period Certain (Fixed Period/Guaranteed Term)
Annuities with a certain period are similar to straight-life annuities. Even if the annuitant dies, the payments will keep coming for a minimum period of time. The annuity payments will go to a beneficiary or the annuitant’s estate if the annuitant dies before the end of the period. Your monthly payments will be lower when you add the period certain.
Joint and Survivor Annuity
A joint and survivor annuity makes payments to both the annuitant and another person, usually a spouse, for the rest of their lives. When you choose a straight-life or period-certain annuity, you get less per payment. You can also name a beneficiary and include a certain period. In the event that both annuitants die before the end of the period, the beneficiary would get the death benefit.
A surviving spouse might get the full amount or a smaller percentage, depending on the contract. In most cases, it’ll be 50% or 75% of what you originally paid.
With this option, the annuitant gets the whole annuity value at once. As a result, the IRS will require a tax payment in the year the money is distributed, which can increase the tax burden.
Although this gives you more flexibility, it increases your chance of running out of money before you die.
Systematic Annuity Withdrawal
With a systematic annuity withdrawal, you can choose the dollar amount and number of payments without worrying about the duration. Fixed amounts are withdrawn on a regular basis.
The downside? There’s no guarantee your income will last forever. It depends on how much your contract is worth.
In addition to taxes owed on the money, you’ll have to pay a penalty of 10% if you withdraw money from your annuity before age 59 ½.
If you withdraw within five to seven years of buying the annuity, you’ll also owe the provider a surrender charge of up to 20 percent. In the beginning, they’re high, but they’ll usually go down every year. There are some annuities that let you withdraw up to 10% of the value of the annuity without paying any fees.
Monthly Payment Calculation
Your monthly payment amount is based on several factors, but two of the biggest are your gender and age. Because women live longer than men, they won’t get as much money as men.
As you get older, your life expectancy goes down. So, for example, a 75-year-old man with a life option gets a higher payout than a 65-year-old.
Your payout option affects how long the payments will last, and that affects how much you’ll get every month. For instance, you’ll get less money if you pick the joint-life option because the payout goes to your spouse after you die.
Last but not least, your payout depends on your insurance company and its expected investment returns. The company will pay you more if it can make 5% of your money instead of 3%.
However, you’ll get more money if your annuity has a fixed payout or a variable payout when returns are higher. Fixed payouts don’t change, and all investment risk is assumed by the insurance company. You’re taking the market risk when you choose a variable payout because the size of the monthly payout fluctuations based on market conditions.
Annuity Payout Tax
Your fixed annuity payment is considered taxable income if you use an exclusion ratio after your contract has been annuitized. You should ask for your exclusion ratio once you choose your payout method, so you’ll know how much is tax-exempt. An exclusion ratio of 80% on a $1,000 monthly payout means $800 is tax-free, and $200 is taxable.
There is a 10% penalty for premature distributions (those occurring before you reach age 5912), and for annuities purchased before Aug. 14, 1982, withdrawals are made using the FIFO method (first-in, first-out).
If you bought your annuity after Aug. 13, 1982, the withdrawal rule is LIFO (last-in, first-out), so earnings come out first. Not only do you have to pay a 10% penalty on the withdrawal, but you also have to pay income tax on any investment gains. Avoid taking money out before age 59 ½, if at all possible.
Choosing Your Annuity Payout
There are a lot of things to consider when choosing an annuitization payout. As you decide which payout option is right for you, here are some things to keep in mind.
- What is the amount? Decide how much you’ll need every month for living or supplementing your retirement.
- The length of time. Estimate how long you need to keep receiving payments. Payout options that guarantee payments until your death might be a good option if you use payments for a lot of your income.
- Insights into legacy. During the accumulation phase, many annuities offer a death benefit that is enhanced for an additional fee.
How Can You Use Retirement Annuity Income?
There are a lot of ways people use retirement annuity income. Depending on your retirement goals, needs, and lifestyle, you’ll want to use it differently.
- Cover your retirement goals. You can use your retirement annuity income for hobbies, travel, and other things you want to do in retirement
- Take care of fixed expenses. As long as you combine annuity income with Social Security, you can use your annuity income to cover fixed expenses such as rent, mortgage, and utilities.
- Cut down on your splurging. Avoid overspending by building a retirement budget around income streams like annuities and Social Security.
The most important benefit of retirement annuity income is that it can be used to protect your retirement savings in the event of unexpected expenses.
Where Does an Annuity Fit Into Your Retirement Plan?
An annuity can be an important part of your retirement plan. To create a well-rounded retirement plan, you can combine it with IRAs, 401(k)s, life insurance, etc.
When you retire, an annuity can replace your paycheck. As long as you live, you’ll keep getting the payout.
Basically, retirement annuities are life insurance policies for retirees. In case of premature death, life insurance protects your family. Your retirement savings are insured against outliving your annuity income.
Your retirement portfolio can be diversified with an annuity, giving you more flexibility.
1. Who buys annuities?
Individuals looking for a steady, guaranteed retirement income should consider annuities. It’s not recommended for younger people or those with liquidity needs to use the annuity because the lump sum is illiquid and subject to withdrawal penalties. Holders of annuities can’t outlive their income stream, so they’re protected from longevity risk.
2. How much does an annuity cost?
You don’t have to pay taxes on anything you gain until you start withdrawing from an annuity. The investments you make in annuities, however, are made after tax. In other words, you cannot deduct your contributions to an annuity from your taxable income.
In contrast to IRAs and 401(k)s, which allow tax-deferred growth, there are no contribution limits for annuities. An annuity allows you to save more money than other types of retirement plans. If you invest in an annuity through a qualified plan, such as an IRA, there are still limits.
The downside is that withdrawals from an annuity are taxed at ordinary income rates, not capital gains rates. You will also have to pay a 10% tax penalty if you withdraw money before you are 59 ½.
Those who purchase annuities within their IRAs and 401(k)s will not receive any additional tax benefits.
3. What is a non-qualified annuity?
The purchase of an annuity can be done with either pre-tax dollars or after-tax dollars. An after-tax annuity is one that was bought with after-tax money. Qualified annuities are ones you bought before taxes. Plan types that are qualified are 401(k)s and 403(b)s. When you withdraw money from a non-qualified annuity, only the earnings are taxed, not the contributions.
4. What is an annuity fund?
Annuity funds are investment portfolios where annuity holders invest their funds. Returns earned by annuity funds determine the payouts annuity holders receive. Premiums are paid by individuals when they purchase annuities from insurance companies. The insurance company invests the premiums into an annuity fund, which consists of stocks, bonds, and other securities.
5. Is an annuity right for you?
“To be honest, anyone can purchase an annuity,” notes Due founder and CEO John Rampton. “But that doesn’t mean that it’s always going to be the right fit for your retirement plans. It’s kind of like insisting that you still squeeze into a pair of skinny jeans.”
“Annuities are ideal if you’re you’re healthy and expect to live a long and meaningful life,” he adds. “If so, then annuities ensure that you will not outlive your savings.”
What if you’re sick? An annuity is probably not something you should buy. When you have a medical condition, your life expectancy may be reduced, or your savings may be outlived due to high medical costs.
Age can also be a determining factor. If you invest in stocks or riskier options when you are younger, you have more time to recover potential losses. If you’re nearing retirement, however, annuities may provide some much-needed safety and predictability.
In addition, you should take into account your other retirement options.
“If you’ve maxed out other tax-advantaged retirement plans like a 401(k) or IRA, and you have the extra money to spare, then an annuity’s tax-free growth can make a lot of sense,” John states.
“If you’re still on the fence, then there’s some good news for you,” he continues. “Almost all annuity contracts offer a free lock period. In most cases, they allow you, the purchaser, between 10 and 30 days to consider the terms of the contract.” You can back out if you don’t like it.