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Annuities 101: What are Annuities & How Do They Work?

Annuities 101: What are Annuities & How Do They Work?

November 18, 2020
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We all have different goals and wishes when it comes to retirement. But almost everyone shares one retirement fear—running out of money during their golden years. It’s easy to take risks in the market when we’re young and still working. However, when income from employment has passed, some turn to annuities. But what is an annuity, and more importantly, could an annuity be right for you? In this annuities 101 guide, we’ll explore what annuities are, the advantages of annuities, and their disadvantages. 

If you’re looking for assistance in managing your investments or creating a personalized investment strategy, speak with a CERTIFIED FINANCIAL PLANNER™ professional at Good Life Financial Advisors of NOVA today! 

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Annuities Defined

In simple terms, an annuity contract is a risk transfer. You’re passing off the risk of running out of money in retirement onto the insurance company in exchange for a safe, steady income stream. So what does the insurance company get in return? In addition to the commission and fees, the insurance company can use your contributions for their own investments. 

Learn more about the different types of annuities in our next blog post, Types of Annuities.

Advantages of Buying Annuities

Purchasers of annuities can enjoy the following benefits:

Predictable Income

When you buy an annuity, you’re buying a steady, consistent income stream. A 3% fixed annuity will earn that 3% each and year for the remainder of the contract, regardless of how the market or economy is doing. Also, certain annuity products offer riders that guarantee a payment stream for the remainder of the contract holder’s life. This helps protects against the risk of running out of money in retirement. There are several ways this works that are beyond the scope of this blog, so we’ll dive into those in our next post.

Tax Deferral

Due to provisions in the tax code, any gains in non-qualified annuities are tax-deferred—that is, you don’t pay taxes until you start pulling money out. This can be a real benefit for high-income individuals who would like to put off paying taxes on current investment gains. Additionally, there are no contribution limits on annuities like there are on IRAs, 401(k)s, and TSP accounts. 

Estate Planning

Investors in annuities can name specific beneficiaries on their annuity contracts. Done properly, this ensures that the assets in an annuity aren’t required to go through the probate process, which can help survivors get access to the money quicker. 

The gains in non-qualified annuities can be structured in a way that can spread a tax burden over the lifetime of a beneficiary. This has become more appealing since the elimination of the stretch IRA due to provisions in the SECURE Act passed in 2019. 

Finally, many annuities offer additional death benefit riders that can act as a form of life insurance without having to go through underwriting. 

Disadvantages of Buying Annuities

You should always understand the tradeoffs you’re making when purchasing an insurance product like an annuity. Disadvantages of buying an annuity include the following:

Commissions and Fees

You’ll notice that annuity products often come with a heavy sales pitch. Why the hard sell? 

Commissions earned on annuity contracts are amongst the highest offered in the insurance business. Investors should carefully evaluate something called contingent deferred sales charges (surrender charges). These come into play if you take out more than you’re allowed in a specific number of years or decide you don’t want the annuity any more. These charges can be steep! 

Also, the income and death benefit riders may not be too good to be true, but they are too good to be free! Always ask what the fees are and what number they’re calculated on. The sad truth is, insurance salesmen posing as advisors often minimize these expenses, or don’t understand them themselves. If you ever get the sense that this is the case…run.

Different Types of Risk

Annuities aren’t risk-free vehicles. Depending on the annuity you choose, you could still be subject to inflation risk, interest rate risk, and even investment risk. Most importantly, the promises made in an annuity are only as good as the insurance company standing beside them. One of the greatest risks with an annuity is that the individual firm you buy the contract from could go out of business.

Tax Considerations

While there are some tax benefits to annuities, there are also tax disadvantages. For instance, although gains are deferred, money that is distributed out of an annuity is taxed last in (gains), first out. Plus, it’s taxed as ordinary income, not at the currently more favorable long-term capital gains rates. If you draw money from an annuity before 59 ½, there are tax penalties on the gains you need to watch out for.

Final Considerations

No matter what an insurance salesman or radio ad says, annuities aren’t a one-size-fits-all solution, and buyers should beware. If it sounds too good to be true, it probably is. Investors should approach an annuity with a healthy dose of skepticism (see above point on lofty commissions). However, just because annuities aren’t the right fit for everyone, it doesn’t mean that they’re not suitable for anyone.

Work with an Independent Financial Advisor

If you have any questions about whether an annuity is right for you, an experienced, truly independent financial advisor from Good Life Financial Advisors of NOVA can help you make an informed decision. Contact us today! 

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Disclosure

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All references to “guarantees” are subject to the claims paying ability of the insurance company and are not backed by any government or government agency. 

Fixed and variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.

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