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Annuities 101: Cutting Through the Confusion

by Community Manager

‎02-03-2014 08:16 AM

Content provided courtesy of USAA.



If you've heard of annuities but aren't sure how they can help you prepare for retirement, here's an introduction that may shed some light on the subject.


"No single financial product is right for every situation," says Scott Halliwell, a CERTIFIED FINANCIAL PLANNER® practitioner with USAA. "But annuities can be really helpful as you build for or settle into retirement. Unfortunately, there's just a lot of confusion about what they are."


Simply put, annuities are designed to be a tool capable of turning your retirement savings into income that can last your lifetime — starting either right away or sometime in the future.


Types of Annuities


Annuities come in a variety of mix-and-match forms:


  • Deferred or Immediate
    When do you want the income to start? A deferred annuity lets you put away money now so that later, if you choose, you can turn it into income that could last a lifetime. An immediate annuity turns a lump sum — perhaps from a 401(k), inheritance or sale of a home — into income right away. "Investors looking for a conservative, guaranteed option for their retirement portfolio might choose a deferred annuity, while a retiree trying to create an additional income stream could use an immediate annuity," Halliwell says.
  • Fixed, Variable or Indexed
    These products offer choices based on an investor's values. A fixed annuity guarantees your principal and provides a contractual minimum rate of return, though the actual interest rate paid is usually higher. A variable annuity allows you to select investments similar to mutual funds, with the chance for higher returns and the potential to lose money. An indexed annuity guarantees your principal and links returns to the performance of a stock market or other index.

There's some crossover between the categories. For example, you can buy a fixed deferred annuity, a variable deferred annuity, a fixed immediate annuity and a variable immediate annuity, depending on your need and tolerance for risk.


"With so many variations of annuities on the market, it's important to understand what you're really getting," Halliwell says. "Don't just blindly accept what you're being told by the salesperson, but also, don't just dismiss annuities out of hand based on bad things you might have heard. In some cases, annuities make sense. In others, they don't."


A Tax Advantage


In addition to providing for future income, deferred annuities can shelter your retirement savings from taxes until you're ready to start taking money out. That means more of your money can keep working for you.


Unlike IRAs, deferred annuities have no limits on how much money you can invest, no income requirements to prevent you from buying one, and won't require you to start taking your money out when you turn age 70½.


Similar to rules governing IRAs, withdrawals before age 59½ are generally subject to a 10% tax penalty in addition to the ordinary income tax you'll owe on the interest received. Besides tax considerations, surrender charges may apply to withdrawals but typically do not if you convert the annuity to an income stream.


"While you can own an annuity inside an IRA, this approach does not provide any additional tax advantage," Halliwell says. "Normally, I only see this when folks are using a deferred annuity as a safe investment option within their IRA, or when retirees want to turn their IRA savings into an income stream."


Income-Shrinking Trends


There are three key reasons why annuities are becoming an increasingly important retirement planning tool:


  • We're living longer. The longer we live, the longer our retirements and the more difficult it is to avoid outliving your money.
  • Fewer Americans are covered by traditional pension plans. Annuities let you take retirement savings — including balances in IRAs and 401(k) and other retirement plans — and essentially turn them into a self-funded private pension.
  • The minimum age for taking Social Security has risen. People born after 1960 won't draw full benefits until they're 67. If you plan to retire before then, an annuity can provide a source of income while you let your Social Security benefits grow.

The bottom line? Plan on being around for a long time, and recognize that retirement income has become more of an individual responsibility than a company or government one. Annuities can be just another piece of your investment portfolio, or they can serve as a valuable financial tool for building that income.

The USAA Publishers Community: Financial advice when you want it.


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