Annuities promise regular, guaranteed payouts just like a pension plan. In fact, in many ways they sound too good to be true. And it doesn’t help that there’s also a lot of misinformation about them out there.

The truth is annuities come in many shapes and sizes, each designed to meet different needs and goals. They all have various pros and cons as well.

So whether an annuity can help or hinder your retirement plans depends on the choices you make when setting one up.

And if you haven’t considered annuities before, it’s time to start.

That’s because on May 23, the House of Representatives passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. (The bill is currently in the Senate waiting to be brought to the floor for a vote.)

The SECURE Act will overhaul private retirement plans. One of its provisions encourages 401(k)-style plans to offer annuities.

In other words, you could soon have the power to fund an annuity using pretax dollars taken directly from your paycheck.

So here’s a quick rundown of the basics…

A One-of-a-Kind Financial Tool

In simple terms, an annuity is a contract between you and a life insurance company. You give the provider some money — either a single deposit or a series of payments over time — called a premium.

The company immediately invests that money. Then anywhere from 30 days to decades later (depending on the contract), it could provide you with regular retirement checks for the rest of your life.

These checks can arrive monthly, quarterly or annually.

So essentially, annuities are a financial tool designed to provide people with a regular, pension-like income.

If your company or union doesn’t offer a pension — or if you’re afraid it could be taken away — that could be music to your ears.

In fact, most people entering into retirement don’t have the security of a pension. So an annuity can take a pot of money and turn it into a guaranteed, predictable stream of lifetime income. It’s essentially the power to create your own pension.

No stock, bank CD or mutual fund can make that promise! In most cases, your principal is completely protected, even from market fluctuations. And you’ll enjoy tax-deferred growth on your earnings.

Of course, annuities are not perfect. There are several risks to be aware of — including taxes and fees.

Also, while all annuities offer “guaranteed” income, complicated jargon gives some of them a bit of wiggle room.

Finally, as I said, not all annuities are created equal.

The sad fact is if you don’t do your homework, trusting the wrong annuity could take a big bite out of your retirement.

For one thing, annuities are usually fixed long-term contracts. In most cases, the money you pay upfront is essentially gone — you’ll only get it back in the form of income checks.

In other cases, you are allowed to ask for the cash back, but only after a certain date. Trying to get your money out of the annuity before then — known as the surrender period — could cost you big. That penalty is called the surrender fee.

Furthermore, if you’re under the age of 59½, trying to get your money early will generally subject you to a 10% tax penalty as well.

Also pay attention to fees, which can run as high as 3.4% of funds under management. In other words, if your annuity has $200,000 in it, you’ll pay $6,800 a year in fees.

It might not sound like a lot, but it adds up. Even fees as low as 1% can have an insidious impact on the bottom line of your investment portfolio, cheating you out of years of retirement income.

Those fees come right out of your account every single year.

Also, just because you are guaranteed income from an annuity doesn’t mean your account will increase in value. If you’re paying too much in fees, you might deplete your pool of cash faster than you expect.

How Your Money Grows — and When You Can Get It Back

There are three main types of annuities — fixed, indexed and variable.

  1. Fixed annuities are usually offered by life insurance companies. You pay a lump sum of cash up front, and the insurance company guarantees it will grow at a fixed interest rate. The insurance company also guarantees your principal.
  1. Indexed annuities are similar. The difference is that their payout is linked but not tied to a specific benchmark — typically a stock index like the S&P 500. Exactly how they work can be a bit confusing. On the bright side, they offer a guaranteed minimum growth rate, so you don’t have to worry about the annuity’s benchmark index tanking. In fact, your principal can also be guaranteed.
  1. And then there are variable annuities — the wild cards of the bunch. If you’ve ever heard an annuity horror story, I’d bet it was a variable annuity under the hockey mask.

You can further categorize annuities by when they start paying out.

An immediate annuity, as you’d probably expect, can give you income right away. You can’t get an immediate indexed annuity, though you can find variable immediate annuities (and all the risks they entail).

But immediate annuities tend to be the simplest and most straightforward.

With an immediate annuity, you pay a lump sum of cash in exchange for a fixed interest rate and a fixed income for life. It can start sending you checks anywhere from 30 days to 13 months after you sign up.

But think twice before handing over that lump sum. Once that pot of money starts paying you income, you no longer have access to it.

So if you give the life insurance company $50,000 and get your first check, you can’t ask to withdraw say, $10,000 for a dream vacation or to put a down payment on a sports car. You get the checks that you get, and that’s it

It might sound like the insurance company is being stingy with your money. But it’s actually using your money to generate stable returns — and that requires a long-term commitment.

In technical terms, the insurance company annuitizes the lump sum you hand over. That is, it figures out how to divide your starting money into regular payouts based on how much you hand over, your life expectancy and other factors.

At that point, you can no longer access the account value or pass along any remaining balance to beneficiaries beyond the stated annuitization terms.

Of course, you are free to spend your income checks on whatever you want.

Here’s to living rich,

Beau Henderson

Beau Henderson
Editor, Strategic Retirement

P.S. There’s way more to annuities than Beau could cover here today… If you want to learn all the ins and outs — and other ways to secure a safe retirement — go here now.

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