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Retirement 101: Everything You Need to Know to Get Started with Annuities Poet and playwright Oscar Wilde once said, "It is better to have a permanent income than to be fascinating." And, if you're just beginning to think about your retirement, truer words have never been spoken. In fact, a study from Allianz Life Insurance Company of North America found that 71% of participants in an employer-sponsored […]The post Retirement 101: Everything You Need to Know to Get Started with Annuities appeared first on Due.

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Poet and playwright Oscar Wilde once said, "It is better to have a permanent income than to be fascinating." And, if you're just beginning to think about your retirement, truer words have never been spoken. In fact, a study from Allianz Life Insurance Company of North America found that 71% of participants in an employer-sponsored plan would like an option that offers guaranteed income for life in their plan.

Wait? Doesn't your retirement plan already include beneficial financial moves that provide a guaranteed income?

No disrespect to 401(k)s and other types of pension plans; they do have their advantages, they don't offer the confidence and protection that annuities provide. As such, it's not surprising that multiple generations have expressed these concerns. No wonder 58% of people want an annuity as a part of their retirement plan.

"Getting some protection against risks within retirement and guaranteeing an ongoing stream of income is a critical, yet often overlooked, component of a solid retirement financial plan," said Matt Gray, assistant vice president of Worksite Solutions, Allianz Life. And, that's exactly the purpose of an annuity.

However, those just starting out with this type of retirement plan may find annuities confusing and overwhelming. So, let's clear the air and break down everything that you need to know about annuities.

How an Annuity Works

Back during the Roman Empire, citizens would make a one-time payment to the annuities. In exchange, they would receive lifetime payments once a year. Soldiers, however, received annual stipends as compensation for their military service. Of course, this has changed over the centuries.

The annuities that we're more familiar with can be traced back to the "Great Depression." As a part of FDR's New Deal, they were originally designed to be a reliable means of securing steady cash flow for an individual throughout their retirement years. The idea being that this would alleviate any fears of longevity risk of outliving one’s assets.

While that still holds true today, an annuity is nothing more than a long-term investment. It's issued by an insurance company and is designed specifically to cover the following goals;

  • Lifetime income
  • Principal protection
  • Long-term care costs
  • Legacy planning

It should be noted, though, that annuities are not investments. It's a contract between you and the insurance company. Being aware of that can help protect you from steep costs if you break the contract.

Additionally, defined benefit pensions and Social Security are two other examples of lifetime guaranteed annuities where retirees will receive a steady cash flow until they pass.

Besides retirement, annuities can also be created to turn a substantial lump sum into steady cash flow. The most well-known example of this would be when someone wins a large cash settlement from a lawsuit or from winning the lottery.

But, when it comes to your retirement, how exactly does an annuity work?

Well, they work in a variety of ways. But, it usually involves you, the client, making either making a monthly, quarterly, annual, or even a lump sum payment to the annuitant, usually the insurance company. You'll make these payments for a specific timeframe, typically 10 to 30 years.

During this time, you'll earn a guaranteed interest rate on your money. When you stop making these payments, generally, when you retire at age 65, you'll get a fixed monthly fee for the rest of your life.

Annuity Types

Let's say that you decide to treat yourself to an ice cream cone. Not only are there a variety of flavors, but there are also different types, such as soft serve, yogurt, gelato, and dairy-free. When it comes to annuities, there are different types tailored to your own preferred taste.

Most of the time, your favorite annuity flavor will be based on factors like income goals, when you want to receive payments, and risk orientation. Annuities can even be structured on the duration of time that the payments can be guaranteed to continue.

So, let's take a closer look at the various annuity types.

  • Fixed. A straightforward annuity where the insurance company promises to pay you a guaranteed rate of interest. Due, as an example, has a payout of 3%. So, on a $100,000 annuity, you would receive $3,000 worth of payments annually.
  • Variable. With this annuity, you choose from a basket of subaccounts, aka mutual funds. While you may earn a better return and a higher payout, this amount depends on the portfolio's gains and losses — which are determined by the performance of the market.
  • Fixed-Indexed. These are fixed annuities. However, there's also a variable rate of interest added to your contract value. The catch? The underlying market index, such as the S& P 500, must be positive.
  • Immediate. Basically, this is a mirror image of a life insurance policy. You'll make a single payment and will receive regular payments one to 12 months after making the investment. Immediate annuities also contain both principal and interest.
  • Deferred. These can be either fixed or valuable. The difference is that you determine when you want to receive them. You may receive less money, but it guarantees an income for you later in life.

Why Buy an Annuity?

According to a Charles Schwab survey, those who are five years out from retirement are anxious about their financial future. The survey specifically found that;

  • 72% are worried about running out of money in retirement
  • 57% are overwhelmed by determining how much they can spend in retirement
  • 60% are worried about not getting – or the thought of not getting – a regular paycheck in retirement
  • 64% are overwhelmed by not being able to maintain their current lifestyle or quality of life in retirement

While an annuity won't solve all of these concerns, it can certainly reduce much of these fears. Mainly because they provide income for life. How much you'll receive depends on variables like which type of annuity you have.

Again, with a fixed annuity, you'll know exactly how much you'll receive. Variable annuities will vary depending on the performance of your investment portfolio.

Regardless, you know for a fact that you'll have a steady income stream coming your way in retirement. And, research has shown that retirees with a guaranteed income are happier than those who don't. They also live longer.

But, that's not the only reason to buy an annuity.

  • Premium protection. This can't be stressed enough. No matter the type of annuity you bought, you will never lose the money you started out with.
  • Tax-deferred growth. You'll only have to worry about taxes when until you start receiving payments. Until then, your money grows significantly.
  • Invest as much as you want. There are no contribution limits.
  • Long-term care. For many, this is an overlooked and costly retirement expense. An annuity can offer a level of insurance against these costs.
  • An asset that beneficiaries can inherit. With the option of a death benefit rider, you can pass your annuity on to your spouse or heirs.

Who Buys Annuities?

To be honest, anyone can purchase an annuity. But, that doesn't mean that it's always going to the right fit for your retirement plans. It's kind of like insisting that you still squeeze into a pair of skinny jeans.

Annuities are ideal if you're you're healthy and expect to live a long and meaningful life. If so, then annuities ensure that you will not outlive your savings.

What if you're unhealthy? Well, annuities might not be your best retirement vehicle option. This is especially true if you also have a medical condition that may decrease your life expectancy or cause you to outlive your savings due to expensive medical costs.

Age can also be a determinant. If you're younger, you can invest in stocks and riskier options as you have more time to recover potential losses. If you're approaching retirement, though, annuities provide some much-needed safety and predictability.

There's also one other major consideration. And that's what your other retirement vessels look like.

If you've maxed out other tax-advantaged retirement plans like a 401(k) or IRA, and you have the extra money to spare, then an annuity’s tax-free growth can make a lot of sense.

If you're still on the fence, then there's some good news for you. Almost all annuity contracts offer a free lock period. In most cases, they allow you, the purchaser, between 10 and 30 days to consider the terms of the contract. If it's not to your liking, you can cancel the contract and receive a full refund.

Annuities vs. Life Insurance

Are there similarities between annuities and life insurance — mainly that they allow you to invest on a tax-deferred basis? Sure.

But, they also couldn't be further apart. It's like proclaiming that mint chocolate chip ice cream is the same as raspberry sorbet. So, let's briefly explain the difference between

Life insurance.

"Life insurance plans provide income for your dependents if you die sooner than expected," explains Janet Hunt for The Balance. "Most life insurance plans can be divided into either term-life or whole life insurance."

Generally, a term life insurance policy spans 10, 20, or more years. A "whole life insurance policy is for the entire life of the policyholder," adds Hunt. "Some term life insurance policies offer the option to be converted into a whole life insurance policy when the term expires."

"Many life insurance policies do offer cash value and income-earning options as well as other living benefits like a critical care coverage option," she states. But, "this is not the main function of a life insurance policy. Its main function is to care for your dependents after your death and pay for end-of-life/final expenses."

Pays out begin when you die and are a single sum.


Annuities, as previously stated, equip you with recurring income throughout retirement. The main purpose is to guarantee a financial cushion just in case you exceed your expected lifespan.

Pays out start when you leave the workforce, typically at age 65. You'll then receive monthly payments for the remainder of your life. However, you can also choose to receive one lump sum.

If you want to pass something along to your family so that they aren't struggling to make ends meet, life insurance is the way to go. If you're concerned about your own financial future, annuities may be the better investment.

Example of an Annuity

An annuity is simply a series of payments that are made at equal periods. For instance, when it pays out, you'll receive a deposit on the first of each month. And, you'll receive these repeating payments for the remainder of your lifetime.

Because annuities are complicated, here's a real-world example.

Let's meet Bill, a 62-year-old aiming to retire in three years. His employer does not offer a pension, and his biggest fear is that he'll run out of money. So, he's looking for a way to supplement his Social Security and the $500,000 in his 401(k).

After meeting with a financial advisor, Bill determines that he'll need around $4,000 to live comfortably throughout retirement. The good news? Social Security will cover half of that. But what about the remaining $2,000?

He can't rely 100% on his 401(k) savings since he'd be in trouble if the market crashes. It's suggested that Bill review annuity options. And, he likes what he sees.

Bill goes ahead and moves $250,000 of his savings to a fixed-index annuity. Rolling this over is tax-free. Best of all? He'll get $1,100 when he retires at age 65 — no strings attached. Also, due to "indexing," the annuity will increase — which will help Bill cover rising costs.

Also, if Bill does pass away once the annuity begins paying out, he can leave it to his children.

What are the Risks Involved in Annuities?

Although we've talked them up a great deal, annuities aren't flawless. As with any type of investment, there are risks and drawbacks involved.

The biggest risk involved is whether or not the insurance company involved will be able to pay your annuity payments. In short, if they go under, don't expect your monthly payments. If that unfortunate event occurs, that could put you in a precarious financial situation.

To put your mind at ease, states individually have life and health insurance guaranty associations. These may be able to present some sort of relief if this happens.

Other concerns include;

  • Investment risk. This is only true of variable risks that can fluctuate depending on the market.
  • Opportunity cost. If money is tight, you may not be able to invest in other retirement plans.
  • Conservative payouts. While annuities do grant security and predictability, the return isn't as high as other investment plans.
  • High fees. Annuities come with a variety of fees that can add up in a blink of an eye. Some fees with mention are surrender charges, insurance charges, investment-management fees, rider fees, and contract fees. There are also early withdrawal fees.
  • It's difficult getting out of an annuity. If you purchased an immediate annuity, not only is it impossible to get out of, you may not be able to into another annuity plan or pass it to a beneficiary. If you can, expect even more fees to be tacked on.
  • Complexity. Since insurance firms offer a cornucopia of rider and options, choosing the right type of annuity is difficult.

Overall, annuities aren't for everyone. Before making this commitment, weigh the pros and cons to ensure an annuity is right for you.

Are Annuity Payments Taxable?

"Annuities are designed to build wealth and income for your retirement through tax deferral," writes Ken Nuss for Kiplinger. "Interest earned in a deferred annuity (the most popular type) is not taxed until withdrawn. Deferring taxes accelerates savings growth because interest compounds faster without withdrawals needed to pay taxes."

When does compounding occur? Only "when interest is paid on previously earned interest," he explains. "Most investments that earn interest, such as money market accounts, savings accounts, certificates of deposit, and most bonds, create taxable income." But, because "you're paying federal (and often state) income tax on it each year, you'll have less after-tax interest to compound, and your savings won't grow as fast."

That's not the case with a tax-deferred investment. Here "all of your interest is compounded until withdrawn," says Nuss.

"Annuities have some unique tax advantages," he adds. "In some cases, they can even be used to pay for long-term care without the usual taxes on distributions! But there are some potential tax pitfalls."

Firstly, you do not have to report the interest you've earned on qualified (pre-tax) and nonqualified annuities (after-tax). "However, qualified annuities held in retirement accounts are subject to required minimum distribution (RMD) rules," states Nuss. That means that you "must take withdrawals each year after you reach age 72."

Nonqualified annuities don't have to play by RMD rules. But, "income withdrawn from all types of deferred annuities is taxed as 'ordinary income,' not long-term capital gain income."

Other tax wrinkles to be aware of are;

  • If you withdrawal before 59 ½, you'll have to pay Uncle Sam a 10% penalty fee.
  • Only the interest portion of a nonqualified annuity is taxable.
  • For deferred annuities, you're required to "withdraw all of the taxable interest first before withdrawing any tax-free principal."
  • Rollovers withdraw for long-term care, and beneficiary ownership is tax-free.
  • Deductions are similar to other qualified plans, such as 401(k)s.

How Can I Cash in My Annuity?

A fixed annuity operates similarly to a CD. After it's matured over a fixed period of time at a guaranteed rate, you have several options to chose from.

  • Life annuitization option. If you want the highest payout, and receive a monthly payment for the rest of your life, this is your best bet.
  • Joint-life annuitization option. Similar to the above, except designed for those who are married. If one of you passes away before the other, the income goes to them. Payouts, however, aren't as high.
  • Period certain annuitization. The annuity's value is determined by a 10, 15, or 20-year time frame. Not only will you get income for life, but this also ensures that there's something left over for your beneficiaries.
  • Life with guaranteed terms. Another option if you want to secure an income stream for life. But, if you pass before the guaranteed payouts are paid out, they go to your estate or beneficiaries.
  • Systematic withdrawals. Here you have to option to select the size of your monthly payments and the number of payments you would like to receive.
  • Lump-sum payment. With this option, you will receive one giant payout. Just be aware that you'll have to pay income taxes when you make this withdraw.

But, that's not all. If you're under the age of 59 ½, you could renew your annuity or roll it over to through a 1035 exchange into a new fixed annuity or another annuity.

What if you need cash right now? Well, you can cash out your annuity whenever you please. You can even opt for a partial or lump sale. Just know that you'll have to pay an 8% to 10% fee. But, the longer your money is invested, the lower the fee.

Cash Value in Annuities

"Cash value, or account value, is equal to the sum of money that builds inside of a cash–value-generating annuity or permanent life insurance policy," writes Sean Ross for Investopedia. "It is the money held in your account." For annuities specifically, fixed deferred annuities have cash value.

"Your insurance or annuity provider allocates some of the money you pay through premiums toward investments—such as a bond portfolio—and then credits your policy based on the performance of those investments," adds Ross.

It is illegal in the United States, "for a life insurance policy to market itself as an investment vehicle." But "many policyholders use their whole life, universal life or variable universal life insurance (VUL) policies to grow tax-advantaged retirement assets." he states.

FYI, term life insurance policies do not build cash value.

Illiquid Nature of Annuities

Annuities are long-term lifetime contracts. As such, they are viewed as illiquid. That's just another way of saying that they can not be easily converted into cash.

Or, at least that's what the Financial Industry Regulatory Authority and the Securities and Exchange Commission have concluded. But, that ultimately depends on the type of annuity and timing.

"It's one of the most pervasive myths surrounding annuities, and it simply isn't true." states the folks over at Raymond James. "You will be expected to pay a surrender charge should you choose to withdraw a substantial portion of an annuity in the early years of your contract (these charges diminish annually before disappearing, usually around year seven), but your funds are accessible. And with most annuities, you can take out up to 10% per year free of fees."

"It's also worth noting that annuities are hardly the only product that charges investors for 'getting out' early," they add. "Some investment products are well known for their early withdrawal penalties, and the sale of most other investments will be subject to market conditions and, perhaps, commissions."

The final verdict? "While an annuity is certainly not the first place to look when confronting an unexpected need for cash, calling them illiquid is just inaccurate."

Surrender Period

Although considering an annuity illiquid, they're not always the most flexible investment retirement option. Case in point, the surrender period.

A surrender period is the minimum amount of time that you must keep your money in an annuity fund. As an incentive for you to not make an early withdrawal, you'll be charged a penalty fee, which is known as a "surrender charge.". At the same, depending on the terms of your contract, this isn't always possible.

The clock starts ticking when you begin depositing funds into your annuity. The surrender period often lasts seven or eight years. However, you may come across periods that are zero, four, ten, or more years.

Surrender will reduce the value and return of your investment. But, over time, these charges begin to drop off.

You can avoid surrender charges by withdrawing up to 10% of your initial investment. Or, you can inquire about waivers for costs related to diagnosis for a terminal illness, if you have to move into a nursing home, or if you leave assets to an heir.

You could also consider annuitizing your contract. If you go this route, you'll convert your lump sum into a series of payments.

If you're head is spinning, that's understandable. The purpose of this guide? To dip your feet into annuities so that you can plan for retirement. In the meantime, schedule an appointment with your financial advisor to ensure an annuity is right for you.

The post Retirement 101: Everything You Need to Know to Get Started with Annuities appeared first on Due.

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