Everyone understands mutual funds, CDs, T-bills and bonds, but when it comes annuities, many people start to look confused. Unlike more popular ways to save for the future, annuities have always had an air of mystic surrounding them. That is a shame because for some people, purchasing an annuity is a smart investment for their financial future.
This short guide can help you learn some basic information about annuities and offer several of the advantages and disadvantages of owning one.
What Is an Annuity?
Before talking about other aspects of annuities, it is important to first realize that unlike other forms of investments, annuities are often considered a form of insurance by safeguarding the holder against running out of money later in life. Annuities allow a person to make a onetime payment or a series of payments to guarantee that the holder of the annuity will to receive monthly payments in the future.
There are two main types of annuities: immediate and deferred. Immediate annuities offer monthly income starting as soon as you purchase it. Deferred annuities start to pay out at a fixed future date. Annuities can provide much needed income for a set period or for the lifetime of the holder depending on the annuity the person owns.
Besides knowing the difference between immediate and deferred annuities, you need to be aware that some annuities are variable, fixed, or indexed annuities. Make sure you know which type you are purchasing. You can find out more about variable annuities from the SEC site1 and other types of annuities on the NAIC website.2
Benefits of Purchasing Annuities
Annuities provide several advantages for owners, but each annuity is different, and therefore it is essential to educate yourself about the particular annuity you are planning to buy. Besides providing a guaranteed monthly income, most annuities offer:
- A great way to defer paying taxes on your income. While you can use your 401(k) and IRA to shield some income from being taxed, both have limitations. Annuities are unique in that they are no limits placed on the amount of money you can use to purchase them. Once you purchase an annuity, the interest generated by the annuity is typically tax-deferred.
- Protecting your money from probate and creditors. For people who worry about probate fees or have a concern that creditors may seize their assets, annuities can provide a much-needed sense of security. Many states treat certain annuities as a retirement accounts and are accordingly protected. Annuities are secure during probate throughout the US.
- The opportunity for your child to qualify for financial aid for school. As long as the owner of an annuity is not yet receiving payouts from an annuity, the government does not require parents to list it as an asset when filling in the Free Application for Federal Student Aid (FAFSA) form. This can help students qualify for need-based financial aid.
The Downside of Annuities
Annuities provide several benefits, but they have their own set of cons you need to consider as well. The downside of annuities include:
- Paying taxes on payouts. While annuities may be a good way to defer paying taxes on income, once you start to receive payouts from an annuity, any payout which is not part of your principal will be taxed as earned income, and therefore will not qualify as capital gains.
- Lots of fees and other costs. Whether you are paying the initial commission which can be as much as 10 percent of the total value of the annuity or covering the annual management fee which may reach 1.5 percent or more, annuities are one of the most expensive financial products to purchase. That doesn't even cover the surrender fee which you may have to pay on deferred annuities you need to cash out early.
Annuities are complex. Always speak with your financial advisor to see if they are the right option for you.