What is an Annuity and is it Right for Me?
Annuities were designed to be another way to have a predictable income. They can be complicated so you need to know what they are and what to ask.
An annuity is an insurance product that uses insurance to help provide an income. There are many forms of annuities but they all provide tax deferral on your investments. They can be complex and not easy to understand. Annuities are sold by insurance companies, some have commissions and others are a fee.
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 a guarantee on return. Fixed-rate annuities are the only fixed-rate product.
2. What does an annuity cost?
If your annuity is a variable-rate annuity that means it is invested in mutual funds or indexes. They still have internal fees associated with them just like an investment account. Most annuities come 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. For example, you may have a step in basis rider that locks in market value to determine the 5% income withdrawal rate.
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, because of the tax-deferral. However, eventually, you or your heirs will owe capital gains on that annuity when it’s cashed in. Annuity vs. IRA – is it right for me?
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 it.