Why Are Annuities Used in Retirement Planning?

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One of the biggest concerns people face when preparing for retirement is determining how their savings will translate into income.

An annuity can potentially help address that concern by creating an income stream for a defined period—or, depending on the contract and options selected, for life.

Another feature is tax deferral. Generally, taxes on earnings aren't due while the money remains within the annuity. Taxes typically become relevant when taxable amounts are distributed.

Certain annuities may also provide benefits to beneficiaries following the contract owner's death.

However, these advantages need to be considered alongside the annuity's costs, liquidity restrictions, potential surrender charges, risks, and other contract provisions.

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Immediate vs. Deferred Annuities

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One way to distinguish between annuities is based on when income begins.

With an immediate annuity, you typically purchase the contract with a lump-sum payment and begin receiving income relatively soon afterward.

A deferred annuity is designed for a later income date. Money contributed to the contract has an accumulation period before the income or payout phase begins.

The right structure depends on factors such as your age, retirement timeline, income needs, financial resources, and long-term objectives.

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Types of Deferred Annuities

There are several types of deferred annuities, and they don't all provide the same level of risk or growth potential.

Fixed Annuities

A fixed annuity generally provides a guaranteed minimum interest rate during the accumulation period, with rates established by the issuing insurance company.

Fixed Indexed Annuities

A fixed indexed annuity credits interest based in part on the performance of a specified market index. Your money isn't directly invested in the index, and the contract typically includes rules that determine how much interest can be credited.

Registered Index-Linked Annuities (RILAs)

RILAs also connect contract performance in part to a market index, but they can expose the contract owner to losses. These products generally establish parameters that affect both potential gains and potential losses.

Variable Annuities

With a variable annuity, contract value can fluctuate based on the performance of the investment options selected. This creates greater exposure to market gains as well as market losses.

Because RILAs and variable annuities are securities as well as insurance products, they are subject to additional securities regulation. 

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What Should You Consider Before Purchasing an Annuity?​

An annuity shouldn't be evaluated based on a single feature.

Before purchasing one, consider how the contract fits within your overall retirement strategy, income needs, liquidity requirements, risk tolerance, investment time horizon, and other financial assets.

It's also important to understand:

How long is my money committed?
Some annuities impose surrender charges if you withdraw more than permitted during a specified period.

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How will my money grow?
Growth can work very differently depending on whether the annuity is fixed, indexed, registered index-linked, or variable.

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What will I pay?
Costs can include contract expenses, investment-related expenses, optional benefit charges, surrender charges, and costs that are indirectly reflected in how returns are calculated.

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What happens if I withdraw money early?
Withdrawals may trigger surrender charges, contract adjustments, taxes, or potential tax penalties depending on the circumstances. They may also reduce certain contract benefits. 

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What happens when I die?
Death-benefit provisions differ among contracts, so it's important to understand what beneficiaries may receive and under what circumstances.

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Annuity Guarantees Are Not All the Same

The word “guaranteed” requires context when discussing annuities.

Guarantees associated with an annuity are generally obligations of the insurance company issuing the contract. The insurer's ability to meet those obligations depends on its financial strength and claims-paying ability.It's therefore important to evaluate not only the features of an annuity but also the company issuing it.

What About Taxes?

Annuities can offer tax-deferred growth, but that doesn't mean distributions are necessarily tax-free.

Withdrawals may create taxable income, and certain distributions taken before age 59½ may also be subject to an additional federal tax penalty. Individual circumstances vary, and tax laws can change, so questions about specific tax consequences should be discussed with a qualified tax professional. 

It's also worth considering the purpose of purchasing an annuity inside an already tax-deferred retirement account, such as a traditional IRA or 401(k), because the annuity does not create an additional layer of tax deferral simply by being held inside that account. 

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Is an Annuity Right for You?

There isn't a universal answer.

An annuity may play a useful role in some retirement strategies, while another financial approach may be more appropriate in other situations.

The decision should come down to how the specific product's benefits, risks, costs, restrictions, income features, and time horizon fit within your broader financial picture.

Before purchasing an annuity, make sure you understand what you're buying, what you're paying, how and when you can access your money, and how the contract supports your long-term goals.

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