When you think of retirement planning, the first investment options you likely think of are IRAs, 401(k) accounts, and maybe pension plans.
An annuity could make sense as part of your retirement plan too. When you sign an annuity contract, you agree to make one large payment or a series of periodic payments in exchange for a guarantee that the insurance company will send you a regular paycheck throughout your retirement.
But not all annuities are created equal — there are several different types, based on specific characteristics we’ll explore in greater detail below. To ensure you buy the annuity that makes the most sense for you and your family, you need to understand what sets them apart.
Types of Annuities
We can segment the wide, complicated world of annuities along a few easy-to-understand lines. These include how you pay the premium, how your premiums are invested, when you begin receiving payments, and how often you receive payments.
When You Receive Payment
Annuities treat payment timing in one of two ways: either you start receiving payments almost immediately after purchasing the annuity, or you have to wait years or decades for payments to start.
As its name suggests, an immediate annuity begins making payments almost immediately. When you sign up for one of these products, you decide if you want to be paid monthly, quarterly, or annually. The time frame you decide on is also the time between signing the contract and when you can expect your first payment.
For example, if you sign up for a quarterly annuity, you can expect your first payment within three months of signing the annuity contract.
When you sign up for a deferred annuity, you’ll need to wait a bit longer for payments. Although you begin paying for deferred annuities when you sign up, they don’t start paying out until a future date stipulated in the contract. This is often the date you turn 59½, though you can usually defer payments beyond then so that your annuity has more time to grow.
How Long You Will Receive Payment
Another major difference between annuities is how long they pay out. Some offer payments for a lifetime, while others only pay for a set period of time. In some cases, you may also be able to access a large, lump-sum payment.
Lifetime annuities, also known as whole-life annuities, offer lifetime income payments. That means you will receive payments for the rest of your life, but there might be a catch.
If you sign up for a lifetime immediate annuity, chances are there won’t be a death benefit. That means that when you die, any value left in your annuity is the insurance company’s to keep. If you live longer than the insurance company expects you to, you end up with a significant windfall.
In some cases, you may be able to purchase a rider that adds a death benefit to the policy. You can also add your spouse to the annuity contract as a second annuitant to ensure they receive income for the rest of their life if you pass first.
If you sign up for a lifetime deferred annuity, it probably comes with a death benefit payable to your designated survivor (beneficiary). Read the contract carefully to make sure though.
A fixed-period annuity is designed to provide periodic payments for a set period of time. That period of time, known as the payout period, can range from five to 25 years.
Fixed-period annuities typically come with a death benefit regardless of whether it’s an immediate or deferred annuity. You can use the death benefit as a supplement to your life insurance coverage, but not a replacement. When you die, the insurance company pays the remaining contract value of your annuity — the sum of all remaining payments — to your beneficiaries. As a result, you (or your family) get what you pay for regardless of how long you live.
On the other hand, a fixed-period annuity has no windfall potential. Because payments stop at a set date, you don’t get anything extra for outliving your life expectancy.
The Lump-Sum Payout Option
Most deferred annuities come with a lump-sum payout option. That means that when you enter the payout phase, you can decide to take a lump-sum payment for the contract value of your annuity, or several payments for the defined period, which could be the rest of your life.
Some immediate annuities also offer a lump-sum withdrawal option after a set number of years. Typically, this option is available in 10 years. If you decide to withdraw your cash early, you’ll have to pay surrender charges. These usually start at 10% of the withdrawn amount and decrease by 1% per year.
How the Annuity Grows
Another important consideration as you shop for your perfect annuity is how the money grows. After all, annuities wouldn’t be worth considering if they weren’t expected to grow over time. These products accumulate value in one of three ways.
Variable annuities have the highest growth potential — and loss potential — of any annuity. When you pay for a variable annuity, the money you pay is invested in sub-accounts that act as mutual funds.
The insurance company uses the money in these sub-accounts to make stock market investments, taking a potentially hefty fee (more than a typical mutual fund management fee) for its trouble. As those investments grow, the value of your annuity grows, as would be the case if you invested the money on your own.
On the flip side, you could also lose money. If your annuity’s sub-accounts take on water in the stock market, you must share in those just like you share in gains when they take place.
A fixed annuity results in a promise from the insurance company to pay you a fixed interest rate on your annuity funds. The rate of interest you receive is set by the insurance company and can vary wildly from one to the next. Be sure to compare your options before signing up to get the best rate.
Although fixed rate annuities are typically the slowest growers, they’re also the safest. They’re not tied to a basket of securities chosen by the insurance company or a stock market index. Instead, they represent a promise to pay a set interest rate, regardless of market volatility.
Fixed-index annuities are tied to a stock market index like the S&P 500, Dow Jones Industrial Average, or Nasdaq Composite index. As the value of the annuity’s underlying index climbs or falls, so too does the value of the annuity itself.
These annuities aren’t quite as risky as variable annuities because they track a benchmark index and are typically highly diversified, whereas variable annuities are reliant on investments hand-chosen by the insurance company. On the other hand, they’re not as safe as fixed annuities because they’re still dependent on market performance.
How You Pay the Premium
There are two ways you can decide to go about making your annuity payments: in regular periodic payments or in one lump sum.
Insurance companies require you to make one lump-sum payment to sign up for a single-premium annuity. In most cases, the minimum payment accepted for this type of annuity is $10,000, but to earn significant income, you’ll need to put up hundreds of thousands of dollars.
You can pay for a flexible-premium annuity with a series of payments. However, this option is only typically available with deferred annuities, and payments are made in the accumulation phase for these annuities.
You can’t make periodic payments to an immediate annuity because the objective of an immediate annuity is to provide near-immediate income. An immediate annuity that you paid into over time would effectively lend you money during the early years, defeating the purpose.
Which Type of Annuity Is Right for You?
Any annuity might be right for you if:
- You’ve Tapped Traditional Retirement Accounts’ Contribution Limits. Traditional retirement investments like IRAs typically come with lower fees, and sometimes better tax benefits, than annuities. So, it’s best to tap out your contribution limits on traditional retirement accounts before shopping for an annuity.
- You Think You’ll Outlive Your Retirement Income. If you’ve tapped out your contribution limits on traditional retirement accounts and you’re afraid you still might outlive your income, an annuity can provide a safety cushion.
- You Need a Bigger Tax Break. The money you use to fund an annuity is contributed on a pre-tax basis. You can write your contributions off to reduce your current year’s tax burden.
When to Consider an Immediate Lifetime Annuity
If you believe an annuity is right for you, you should consider an immediate lifetime annuity if:
- You have a large sum of money to invest in your retirement
- You’re worried about your retirement income running dry
- You’re relatively healthy
Immediate lifetime annuities are perfect in this case because they provide income for a lifetime. However, it’s important that you’re healthy because you must live as long as the insurance company expects you to in order to access the full value of the annuity in most cases.
When to Consider an Immediate Fixed-Period Annuity
You should consider an immediate fixed-period annuity if any of these situations apply to you:
- You have a large sum of money to invest
- You need to reduce your tax burden on a windfall, such as a big signing bonus for a new job
- You’re afraid you may not live as long as the insurance company expects you to
Immediate fixed-period annuities help with financial windfalls because the premium you pay is tax-deferred. That not only reduces your tax burden in the current year, but it could also reduce the overall tax burden of your windfall by keeping your tax bracket low as you receive payments.
Moreover, if you’re afraid you may not live as long as the insurance company expects you to, a lifetime annuity might mean you don’t get what you pay for. Fixed-period annuities typically come with death benefits, so if the value of your annuity outlives you, that value is added to your estate and paid to your beneficiaries.
When to Consider a Deferred Lifetime Annuity
You should consider a deferred lifetime annuity if:
- You’ve tapped out other retirement contribution limits
- You need more recurring income than your traditional retirement accounts can provide
- You’re afraid you might outlive your expected retirement income.
Traditional retirement accounts like 401ks and IRAs typically come with lower fees than deferred annuities. But if you’re not sure your retirement savings will support your standard of living in retirement or last your entire life, those annuity fees are worth it. So a deferred lifetime annuity is a great choice if you’ve tapped out contribution limits on more traditional retirement accounts.
When to Consider a Deferred Fixed-Period Annuity
You should consider a deferred fixed-period annuity if:
- You’ve tapped out other retirement contribution limits
- You expect your retirement to last, but want a buffer period to get you through the transition to fixed income
A deferred fixed-period annuity could provide you with five or 10 years of extra income as you enter your golden years. This could be the perfect buffer to get you used to living on a fixed income.
Every annuity is different, so it’s important to read your annuity contract carefully and make sure you’re signing up for the product that fits you best.
It’s also important to remember that annuities are tax-deferred investments. That means you won’t pay taxes on the money you contribute to your annuity, but you will pay ordinary income tax on the payments you receive.
Speak to a financial professional to learn more about how an annuity may affect your retirement plan and whether or not it’s a good option in your unique situation.