An annuity is an insurance product that can pay you an income on a consistent basis. There are many forms of annuities but they all provide tax deferral and some type of guaranteed income. They are sold by companies that pay their agents commissions. What you want to do is ask some crucial questions before purchasing one.
1. How much is the upfront cost to buy this annuity?
Fixed annuities give you a fixed rate of return for a specified time and have the lowest cost. Variable annuities are invested in mutual funds and your return is variable, based on how it is invested. Expenses are higher depending on the extras added to the contract (called riders) and how it’s invested. Typical costs range from 5-8% and can come with steep penalties if you want to cancel. Your return is NOT guaranteed but the amount you can withdraw, without penalties, is guaranteed. For example you buy a variable annuity for $100,000 and they guarantee a 5% withdrawal rate. Every year you can withdraw up to $5000 out of the annuity without penalty. The account value will fluctuate based on the investments. There is NO guarantee on the return. People confuse the withdrawal rate with guarantee on return. Most inexperienced brokers do not explain this well and you believe you have a fixed or guaranteed return. When your policy value goes down you ultimately be disappointed. Fixed rate annuities are the only fixed rate product.
2. How long before I have no surrender charges? What other charges are there?
If you buy A shares you pay more of an upfront charge for the annuity but can withdraw the money later without penalty. Any other share of annuity comes with a 7 to 10 year surrender charge that decreases the longer you have it. Riders on a contract also add to the cost and can be 0.50% up to 1.5% depending on the extras.
3. I want guaranteed income, is an annuity right for me?
If someone wants you to take all of your retirement funds and put them in an annuity, you need to question their intentions. A retirement account is already tax deferred and there are plenty of ways to draw an income from them. Money outside retirement accounts is a better place for annuities and if you are afraid of investing in the market some annuities can offer some attractive features. However an annuity does not eliminate risk, it just allows an alternative way to receive income. Always consult your CPA on the tax benefits of an annuity. Fee based planners are better to consult with as there is no incentive to sell commissioned based products.
Ultimately you need to understand what you are buying and how it works. If you have more questions make sure you understand the answer before you buy.