What Should I Consider When Buying an Annuity?

When I worked as a licensed financial coach, many of my clients purchased annuities to provide income during retirement. The investments can help provide financial security in your later years.

Knowing what to consider when buying an annuity helps you determine which type might be right for you. The factors include liquidity needs, fees, payout options, and taxes.

What Is an Annuity?

An annuity is a contract with an insurance company that allows you to invest a sum of money in exchange for periodic payments over a timeframe, typically during retirement. These payments can provide income and financial security for a set number of years or your lifetime.

You can choose between fixed and variable annuities. The option you select depends on your financial goals, risk tolerance, and income expectations.

Fixed annuities

A fixed annuity provides a guaranteed payment amount over time. Knowing how much you’ll receive with each payout makes this type of annuity suitable for financial stability and predictability in retirement.

Fixed annuities have the following benefits:

• Steady payments

• Tax-deferred growth on the investment amount

• A range of payout options

• Periodic payments for a set number of years or a lifetime

The trade-off for these benefits is a typically lower return on investment compared to growth-oriented options.

Variable annuities

A variable annuity provides payouts dependent on the performance of the underlying investments. The performance of the stocks, bonds, or other investments offers the potential for higher returns.

Variable annuities are suitable for you if you are comfortable with market risk and want to grow your income. The trade-offs include:

• Fees and potential surrender charges are higher.

• Payment amounts are not guaranteed.

• Monthly income could be significantly lower than expected in down markets.

The following factors should be considered before buying an annuity.

Fees

An annuity’s fees are typically higher than those associated with other investments, impacting your overall returns. Common fees include:

• Administrative fees: The costs of managing and servicing the contract can range from 0.1% to 0.5% of the annuity’s value annually, which adds up over time.

• Surrender charges: Early withdrawals from an annuity can be as high as 7% of the withdrawal amount during a specified period, often 5 to 10 years, and decrease over time.

• Mortality and expense fees: Variable annuities compensate the insurance company for the risk it takes in providing you with lifetime income. The fees usually range from 1% to 1.5% of the contract’s value annually.

• Rider fees: Optional features that provide additional benefits, such as guaranteed income for life or protection against investment loss, typically cost between 0.5% and 1% or more of the annuity’s value.

Since annuities typically have a higher fee structure than mutual funds, exchange-traded funds (ETFs), or other retirement investment vehicles, be sure to compare the costs and understand how they impact your returns over time. The guarantees and security might be worth the fees if an annuity aligns with your retirement goals.

Tax Obligations

Annuities are taxed differently based on how they are structured and funded, as well as during the accumulation phase and when you start receiving payments:

• Tax-deferred growth: The investment in an annuity grows tax-deferred. The earnings are taxed as ordinary income upon withdrawal.

• Qualified and non-qualified annuities: An annuity purchased through a tax-advantaged retirement account, such as an Individual Retirement Account (IRA) or 401(k), is considered qualified. The contributions and earnings are taxed as ordinary income upon withdrawal. In contrast, an annuity purchased with after-tax dollars is non-qualified. The earnings are subject to tax upon withdrawal, whereas the principal is returned tax-free.

• Early withdrawal penalties: Annuity withdrawals before age 59 ½ might be subject to a 10% early withdrawal penalty as well as ordinary income tax.

Understanding the tax implications of annuities helps you determine the timing and nature of withdrawals. Coordinating your withdrawals with your other income sources helps minimize your tax exposure.

Payout Options

The annuity payout options let you customize how and when you receive income. Ensure the payments align with your retirement goals and financial needs.

Common annuity payout options include:

• Lump-sum payment: A lump-sum payment provides immediate liquidity but can result in a substantial tax burden. You receive no guaranteed income over time.

• Life-only payments: Life-only payments are based on your life expectancy and typically provide the highest payout amounts. These payments stop when you pass away, leaving no benefit for your heirs.

• Joint and survivor payments: Joint and survivor payments provide income for your spouse after you pass away. They are usually reduced to 50% or 75%, depending on the contract.  

• Period-certain payments: Period-certain payments guarantee income for a set period, such as 10 or 20 years. If you pass away during this time, your beneficiary will receive the remaining payments.

Consider the following factors when deciding on the best annuity payout option for you:

• Long-term financial needs

• How the annuity fits into your retirement strategy

• Life expectancy

• Need for liquidity

• Whether to leave a financial legacy for your heirs

*This information is for educational purposes only.