Investing 101 Are Annuities the Right Investment for Your Retirement? Read the Article Open Share Drawer Share this:Click to share on Twitter (Opens in new window)Click to share on Facebook (Opens in new window)Click to share on Tumblr (Opens in new window)Click to share on Pinterest (Opens in new window)Click to share on LinkedIn (Opens in new window) Written by Mint.com Published Jan 8, 2013 5 min read Advertising Disclosure The views expressed on this blog are those of the bloggers, and not necessarily those of Intuit. Third-party blogger may have received compensation for their time and services. Click here to read full disclosure on third-party bloggers. This blog does not provide legal, financial, accounting or tax advice. The content on this blog is "as is" and carries no warranties. Intuit does not warrant or guarantee the accuracy, reliability, and completeness of the content on this blog. After 20 days, comments are closed on posts. Intuit may, but has no obligation to, monitor comments. Comments that include profanity or abusive language will not be posted. Click here to read full Terms of Service. Do you want guaranteed income for life? Who doesn’t? That’s why insurance companies are ramping up their marketing of annuities. But before you buy in, you should know what you’re getting into. Annuities are not that easy to understand and they may not be right for every retirement situation. Here are some basics to understand, plus some pros and cons. What are Annuities? Annuities are financial contracts issued by a life insurance company that offer tax-deferred savings and a choice of payout options – income for life, income for a certain time period or a lump sum – to meet your retirement needs. Because an annuity contract gets tax-deferred treatment, the IRS may impose an early-withdrawal penalty of 10 percent for some distributions if they’re taken before age 59 ½. Types of Annuities When buying an annuity, you’re trading a lump sum of money in return for a stream of income, but annuities come in many flavors, which can make them confusing. The two major categories of annuities are “immediate” and “deferred.” With an immediate annuity, payments to you start immediately or within one year of the policy’s issue. You use this type when you want to start taking income as soon as possible. A deferred annuity has two phases. During the accumulation phase, you defer those income payments, letting your money grow on a tax-deferred basis for several years. Then there’s the payout phase, when you start receiving scheduled payments. There are a few types of deferred annuities to consider: Fixed annuity. The insurance company agrees to pay you no less than a specified rate of interest during the time your account is growing. It also agrees that the periodic payments will be a specified amount per dollar in your account. These payments may last for a definite period, such as 20 years, or an indefinite period, such as the lifetime of you and your spouse. Variable annuity. If you want more access to more investment options, you can choose from among a range of them, typically mutual funds, to invest your purchase payments. The rate of return on your payments, and the amount you eventually receive, will vary depending on the performance of the investment options you have selected. Indexed annuity. A blend between a fixed and a variable, where the insurance company invests in a mix of stocks and bonds designed to credit you with a return based on changes in a particular index, such as the S&P 500. In a falling stock market, indexed annuity contracts guarantee a minimum return, typically three percent. The Pros and the Cons of Annuities Regarding immediate annuities, guaranteed income for life is a great benefit, but it comes at a cost. First, you’re giving up access your money in exchange for the income stream. Therefore, your wisest move is to invest with only a portion of your total portfolio. Additionally, most immediate annuities provide for fixed payments, which aren’t adjusted for inflation. While we may be in a low-inflation environment today, what happens if prices rise substantially during your annuity’s payout period? Also to consider: By investing in an annuity, you’re also investing in the company that issues it. That guaranteed stream of income is only as good as the financial stability of the company writing the contract. As we all learned just a few years ago, insurance companies – even the biggest ones – can run into major problems. Deferred annuities also share the same lack of liquidity as immediate annuities, and they also have some additional downsides. While insurance companies market their tax advantages, there are four big issues surrounding those benefits: Tax rate: When you start withdrawing money, the earnings (but not the principal) will be taxed at your ordinary income rate, not the lower capital-gains rate typically applied to investments held for more than one year, like stocks, bonds and mutual funds. That can add up to big tax payments, especially for those in high tax brackets. Tax-advantaged accounts: There are some financial advisers or insurance agents that recommend variable or indexed annuities for accounts that are already tax deferred, like IRAs and 401(K)s. That’s absolutely unnecessary, because those accounts are already tax advantaged. If someone tries to sell you a variable annuity to hold in a tax-deferred account, head for the exit. Estate planning: When it comes to annuities and estate planning, proceeds from most deferred annuities don’t receive a “step up” in basis (when an asset’s value is priced at the higher market value at the time of inheritance rather the value at which it was originally purchased. Other investments (like stocks, bonds and mutual funds again) do provide a step up in basis at the owner’s death, which can limit tax liability for the heirs. Deferred annuities can’t offer that benefit. Fees: But the biggest con for this annuity type is the sky-high costs. Mortality and expense charges, administrative fees, fund expenses, charges for special features and the salesperson’s commission can eat up 2% to 3% of your investment value every year. Questions to Ask If an insurance salesman or financial advisor brings up the subject of annuities, here are six questions you should ask right straight away: What type of annuity is this, and why are you recommending it for me? How much will I pay in the first year of the contract, and then how much in subsequent years? What will be your first-year commission on the contract, and then what will you earn in subsequent years? (You want to understand the total costs, from “mortality and expense” charges to the admin fees.) Have I already maxed out my IRA, 401(k) and other tax-deferred vehicles? Should I tie up my money with this annuity? Will I have ample liquidity outside of it if I do? How is this insurer rated by AM Best, S&P, Moody’s and Fitch? If you’re still considering annuities to secure income in retirement, make sure you weigh the potential benefits as well as the risks, and understand the complications of these saving vehicles before handing your money over. Vanessa Richardson is a freelance writer in San Francisco who writes about small business and personal finance. 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