What are annuities?

One of the most important concerns of retirees is the possibility of running out of money during retirement. Social Security benefits continue throughout retirement, as do pensions. Whether one’s personal savings will last is a function of investment returns and expenses. Increasingly, retirees are adding annuities to the mix. An annuity is a promise by a person or organization to make a series of payments. During retirement an annuity can be an additional income source that can’t be outlived. A “deferred annuity” is one that is in an accumulation phase, and an “immediate annuity” is one that begins payments when it is acquired.

Annuity benefits.
The value of an income stream for life is readily apparent. Today’s annuities have additional benefits that may not be so obvious.

Tax deferral.
During the accumulation phase of an annuity, there are no income or capital gains taxes on the investment buildup. The same is true of IRAs and 401(k) accounts, but with annuities there is no dollar limit on contributions. Caveat: When gains eventually are distributed, they will be taxed as ordinary income, just as they are from IRAs and 401(k)s.

A wide range of investment choices.
Annuity companies have developed many investment strategies from which to choose during the accumulation phase of the annuity. These may range from stock and bond funds, which have the usual market risk and reward characteristics, to guaranteed interest rates, which are based on the claims paying ability of the issuer. Some companies offer “floors” under the value of the annuity, in order to limit the downside risk.

Tax-free transfers among investment choices.
When one rebalances a taxable investment portfolio, selling investments that have done well or achieved their targets in order to maintain a consistent risk/reward profile, there can be taxes to pay. In contrast, changing the underlying investments in an annuity is not normally subject to income tax.

Types of annuities
During the savings years, to generalize, there are two types of annuities:

Deferred variable annuities invest in the financial markets. They offer the possibility of substantial growth, but also carry the risk of loss. These annuities are better for investors with long time horizons who won’t be severely upset by market fluctuations.

Deferred fixed annuities, in contrast, provide for a fixed rate of return for a number that is guaranteed by the issuer. This approach may be better for the conservative investor who puts a premium on avoiding market volatility. With each of these products, earnings will compound on a tax-deferred basis. Tax penalties will apply to withdrawals before age 59½. During retirement, when distribution becomes important, there are also two ways to go.

Immediate variable income annuities are linked to the financial markets. Although payments will be made for life, the amount of the payments will vary with the success of the investment strategy. Because there is a chance that the payments can grow over time, this approach has a chance of keeping up with inflation. However, the payments may go down if there are financial market reversals.

Immediate fixed income annuities offer a stated monthly payment—period. Market volatility becomes someone else’s concern, at least as it relates to this retirement resource.

An intermediate choice, the deferred fixed income annuity, starts payments at a future date. The delay increases the size of the income payments.

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