A retirement annuity is an insurance product that pays an agreed amount for an agreed term or period. It offers a way to use income on a tax-free investment, and only the profits or returns are taxable. It is a useful investment for high-income individuals who have maximized benefits of an I.R.A. and 401(k). As a product sold by insurance brokers and financial planners, there are considerable expenses and commissions. While there are advantages, one must be careful to consider all parts of the annuity and alternatives with lower costs.
Immediate Versus Deferred
One can choose whether to take payments immediately after the investment or to defer them until a later time. The form of payout can be a lump sum or periodic payments spread over time. Further, one can set payments for a term of years or guaranteed for life. Deferred payments accrue during the agreed non-payment period and increase the overall return on investment by compounding. One can convert a deferred payment structure into an immediate payment investment; however, withdrawal of funds carries significant penalties.
Fixed Versus Variable Payments
One can choose whether to receive a fixed income set out in the agreement and paid over time or variable income that will rise and fall with the value of the investments selected for the annuity. The fixed annuity is straightforward, and the insurance company selects the investments. The variable option permits the owner to select the investments; however, the insurance company charges a management fee to handle the investments. Both forms of the periodic payments can have lifetime payment guarantees and the right of survivorship for a spouse.
Advantages of a Retirement Annuity
The primary advantages are tax-free investment and deferred taxation on the profit, and an unlimited investment amount. Tax-free growth is a powerful incentive, and one that permits full benefits of the investment. It can complement social security and pension income. Some investors use funds from an I.R.A. or 401(k) to purchase an annuity to generate immediate income.
Disadvantages of a Retirement Annuity
The primary disadvantages of a retirement annuity are the costs and potentially hidden costs. The agreements can be complex, and fees and charges may not be easy to understand. An initial sales commission of up to ten percent is a significant cost. The management fees for variable investments can reach three percent per year. For some investors, the commissions and expenses can take a large part of expected returns.
Is an Annuity Right for You
The advantages of a retirement annuity are the tax-free investment feature and deferred taxation on profits. The disadvantages are no access to funds, high expenses, and annual fees. There are withdrawal penalties including contract penalties for withdrawal before five to seven years and ten percent tax penalties for early withdrawal before age 60. For many investors, a no-load mutual fund would charge far less, in the range of one to two percent, and without large sales commissions.
Compare Before You Buy
Many experts feel that insurance companies urge investors, and particularly seniors, to purchase annuities. It is important for investors to consider the terms of an annuity carefully and to compare it to alternatives with lower expenses and greater flexibility. Variable funds carry risk associated with the underlying investment index which can be a group of stocks or the some reflection of the overall market.