As you approach retirement, one of the most important considerations is securing reliable income streams that will support you through the remainder of your life. Alongside Social Security, pensions, and investment payouts, annuities can be a valuable tool for creating an additional layer of financial stability during retirement.
An annuity is essentially a contract between you and an insurance company. You opt to either make a lump-sum payment or a series of payments, and in return, the insurance company agrees to provide you with regular financial payments during retirement.
There are two main types of annuities to consider: immediate and deferred. Knowing which option is right for you will depend on when you plan to retire and how soon you will need to start receiving payouts.
Key Takeaways
- Immediate annuities provide income right after purchase, ideal for those nearing retirement.
- Deferred annuities offer tax-deferred growth, suitable for long-term retirement planning.
- Key differences between immediate and deferred annuities include timing of payouts and growth potential.
- Tax implications vary between annuity types, affecting retirement income and estate planning.
- Professional advice is crucial in selecting the right annuity based on individual financial goals and risk tolerance.
Immediate vs. Deferred Annuities: An Overview
Before deciding which annuity option is right for you, it’s helpful to understand why people choose annuities in the first place. Annuities offer three main benefits that make them a great option for retirement planning:
- Guaranteed income: You receive periodic payments for a specific amount of time, either a fixed number of years or the remainder of your (or a spouse’s) life.
- Death benefit protection: If you or a loved one passes away before the annuity is fully paid out—and your contract includes this provision—your beneficiary will receive a specific payment as a death benefit.
- Tax-deferred growth: Perhaps the biggest advantage is that you pay no taxes on the income and investment gains from your annuities until you withdraw the money, allowing your retirement savings to grow even more.
The key difference between immediate and deferred annuities is in the timing:
Immediate annuities begin payments within 12 months of the purchase date and are usually bought with a single premium payment. This option works best for people who are already in retirement or very close to it.
Deferred annuities delay these periodic income payments for at least 12 months after purchase, with payments deferred until a maturity date mentioned in the contract—think 5, 10, or 20 years. This option is usually better for people who are several years away from retirement.
Immediate Annuities
Immediate annuities are straightforward financial products for people who need income right away. They are usually purchased with a single lump-sum payment, and you can begin receiving payments as soon as one month to one year after purchase.
Benefits and Drawbacks
The most significant advantage of an immediate annuity is in the name–you get the income immediately. This makes it a great choice for new retirees who need to replace their employment income quickly.
The payments are typically a fixed dollar amount, such as $100 or $500 per month. However, it’s important to note that these fixed payments don’t automatically adjust for inflation, which means your purchasing power may decrease over time. If this is a concern, you can opt for a Consumer Price Index (CPI) adjustment to help protect against inflation.
Types of Immediate Annuity Contracts
There are several contract options to choose from, each with different benefits:
- Straight life annuity: The insurance company makes periodic payments throughout your entire lifetime, guaranteeing you can never outlive your income.
- Life contingent with period certain: Payments are guaranteed for a fixed period (such as 10 or 20 years), even if you pass away during that time.
- Life contingent with refund feature: Payments continue throughout your lifetime, and if you die before receiving payments equal to your original premium, the remaining amount goes to your beneficiary.
- Joint and survivor annuity: Designed for couples, this option continues payments as long as either spouse is alive.
- Period certain annuity: Payments are made for a specific time period (5, 10, or 20 years), and if you die before the period ends, payments continue to your beneficiary until the term is complete.
Ideal Candidates
Immediate annuities are worth considering if you’re concerned about outliving your financial resources during retirement. The payment amount you receive depends on several factors: the annuity option you select, your age, gender, and the mortality tables used by the insurance company.
Important
Ideally, the annuity amount should be sufficient to cover your basic living expenses, providing a foundation of security for your retirement income.
Deferred Annuities
Deferred annuities work differently from immediate annuities. With a deferred annuity contract, you won’t receive income payments until at least 12 months after signing the contract. This delay allows your money to grow during what is called the “accumulation phase.”
There are several different types of deferred annuities—fixed, indexed, and variable—that will determine your rates of return:
- Fixed annuities provide a specific and guaranteed rate of return on the contributions to the account.
- Variable annuities pay an interest rate that fluctuates based on the investment performance chosen by you, the account owner.
- Indexed annuities pay an interest rate based on the performance of a market index, such as the S&P 500.
Benefits and Drawbacks
- Tax-deferred growth: The primary advantage of deferred annuities is the ability to grow your money tax-free until you begin taking distributions. This can provide a major boost to your retirement savings over time, especially if you are still several years out of retirement.
- Flexibility in funding: Unlike immediate annuities that typically require a lump sum payment, deferred annuities can often be funded through regular contributions over time, making them more accessible for people still building their retirement savings.
- Market exposure considerations: Depending on the type of deferred annuity you choose, your money may be subject to market fluctuations. Variable deferred annuities tie your retirement savings to market performance, which can mean higher growth potential but also increased risk.
- Surrender charges: Many deferred annuities come with surrender charges if you need to access your money early, which can limit your flexibility.
Ideal Candidates
Deferred annuities work best for people who are further out from retirement. If you’re in your 40s or 50s and looking to supplement your 401(k) or IRA savings, a deferred annuity can provide additional tax-advantage growth. They’re also suitable for people who have maximized other retirement account contributions and want other vehicles for tax-deferred savings.
Immediate vs. Deferred Annuities: Key Differences
| Immediate Annuities | Deferred Annuities | |
|---|---|---|
| Payment Start | Within 1-12 months | 12 months or later |
| Funding | Single lump sum | Lump sum or periodic payments |
| Growth Phase | No accumulation period | Accumulation phase before payout |
| Best for | Current or near retirees | Pre-retirees with time to grow savings |
| Income | Immediate and predictable | Future income that varies based on type selected |
| Tax Treatment | Payments are partially taxable immediately | Tax-deferred growth until withdrawal |
Tax Implications and Tax Efficiency in Retirement
When you receive payments from immediate annuities, only a portion is taxable. The part that represents a return of your original investment is not taxed, while the earnings portion is taxable as ordinary income.
During the accumulation phase of deferred annuities, all growth is tax-deferred. When you begin taking distributions, the earnings are taxed as ordinary income, while your original contributions come out tax-free. This is particularly helpful if you expect to be in a lower tax bracket during retirement.
Annuities in Estate Planning
Both types of annuities will play an important role in estate planning. Most annuities offer death benefits, which provide financial security for your beneficiary. Annuities typically pass directly to named beneficiaries through a simple transfer.
Note that beneficiaries who inherit annuities may face different tax implications than the original owner.
How To Choose the Right Annuity for Your Retirement Plan
When selecting which annuity is right for you, consider your timeline. Ask yourself if you are already in retirement and need funds immediately, or if you are planning for retirement several years away.
Another factor to consider is your risk tolerance and how comfortable you are with market fluctuations before deciding between fixed or variable annuities, which offer more potential growth with more risk.
Look at other income sources you have, such as Social Security, pensions, and other retirement accounts, as well as whether you need this money to be accessible for emergencies.
How Do Annuities Compare to Other Retirement Income Options Like 401(k)s or IRAs?
Annuities offer you guaranteed income you cannot outlive, which 401(k)s and IRAs don’t provide. Annuities work best as part of a diversified retirement strategy rather than a complete replacement for traditional retirement accounts.
What Are the Potential Risks Associated With Investing in Annuities?
The main risks include inflation eroding your purchasing power, market risks (for variable annuities), and limited liquidity if you need to access your funds early.
Can Annuities Be Adjusted or Cashed Out if Financial Needs Change?
Most annuities have limited flexibility after purchase. You may be able to cash out, but you will likely face significant surrender charges, especially if you withdraw early in the contract period.
The Bottom Line
Annuities can be an excellent option for people looking for an additional source of income during retirement. Whether you choose an immediate or deferred annuity will depend on your life stage, financial goals, and retirement timeline.
Before signing any annuity contract, it’s essential to speak with a qualified financial advisor. They can help you evaluate different products and ensure the annuity you choose makes sense for you and your family. Remember, annuities are long-term commitments, so taking the time to make an informed decision will help you achieve your goals of financial security.