Laura answers a question about annuities and whether you should buy one for retirement income.
Laura answers a question about annuities and whether you should buy one for retirement income.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions!
Today's question comes from Marsha, who says, "I'm 68 and plan to retire at 70. I work for a university, and our retirement is with TIAA. They've suggested that I buy an annuity when I retire. I know some experts don't like annuities–how do you feel about them?"
Thanks for your question, Marsha! Indeed, people have strong opinions about annuities, so I'm glad you asked the question. I'll review how annuities work, what I think about them, and whether you should consider buying one.
Welcome back, everyone, and thanks for joining me. I'm Laura Adams, an author, personal finance influencer, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
If you're not already subscribed to the podcast, that's the best way to ensure you never miss an episode. There are now two weekly shows that come out on Wednesdays and Fridays. If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email using my contact page at LauraDAdams.com.
What Is an Annuity?
An annuity is a contract between you and an insurance company that guarantees certain financial benefits. It shifts risk away from you and onto the insurance company. The primary risk an annuity reduces or eliminates is running out of money in retirement.
Since fewer Americans get pensions from employers, an annuity may complement your other retirement assets, such as savings, investments, and any Social Security retirement benefits. In fact, Social Security is the granddaddy of annuities because those who qualify get retirement benefits guaranteed by the federal government that are adjusted annually for inflation for life.
Institutions and professionals sell annuities, such as insurers, banks, brokerages, and financial advisors. The investment firm that manages Marsha's retirement, TIAA, is one of the largest pension funds in the U.S. It stands for Teachers Insurance and Annuity Association of America. They manage retirement accounts for workers in many fields, including universities, government, nonprofits, and healthcare.
Types of Annuities
You can purchase an annuity by making a lump sum payment or multiple payments over time, called premiums. In return, the annuity provider invests your money and typically gives you a series of payments, known as annuitization.
There are two basic types of annuities to get familiar with.
How Do Income Annuities Work?
An income annuity provides income immediately or at least within a year after you buy it. You make a lump sum payment, called a single premium, and start receiving an income stream.
Let's say you become a widow and receive a life insurance payment of $1 million after taxes. If you want to create a monthly income stream, you could purchase a fixed annuity instead of investing that money in the stock market. The income you'll receive depends on your age, gender, home state, and interest rate when you buy an annuity.
For instance, if you're a 40-year-old female, a $1 million annuity would give you a little over $4,700 monthly for life. Purchasing the same annuity at age 60 would pay out just over $5,700 per month. A shorter life expectancy allows you to receive more income from an annuity, which is why older people typically purchase them.
With a fixed annuity, you receive a fixed rate of return on your money for life or a specific period. No matter what happens in the financial markets, it's a guaranteed, predictable income stream.
How Do Tax-Deferred Annuities Work?
The other broad category is tax-deferred annuities, where you receive income at a future date. You make one or multiple contributions during the annuity's "savings phase" and then receive income either as periodic payments or a lump sum during the "distribution phase." The payout doesn't begin for at least a year after your last premium payment but may be deferred by up to 40 years.
A tax-deferred annuity is similar to a retirement account, where you set aside money over time to access it in the future. In fact, you can own a deferred annuity inside a retirement account, such as a traditional IRA, 401(k), or 403(b), which is likely Marsha's situation.
One advantage of a tax-deferred annuity not inside a retirement account is that you can contribute as much as you like. Unlike tax-advantaged retirement accounts, annuities have no annual contribution limits. (unless you own them inside a retirement account). That can be particularly helpful if you're close to retirement and must catch up.
There are tax-deferred fixed annuities that pay a fixed, guaranteed return for a period or life. While your payment won't change, it may be lower than other annuity options.
You can also buy tax-deferred variable annuities, where your return can go up or down depending on an economic index or underlying investments you select, allowing you to benefit from any market growth. The income stream may have a minimum guaranteed amount but can increase depending on market performance.
Unlike stock market investments, some variable annuities guarantee the return of your original investment at the end of a holding period, such as ten years. However, remember that variable annuity benefits come with a cost because you must pay fees when buying one. I'll talk more about fees in a moment.
What Is a Qualified Annuity?
I mentioned that you can own an annuity inside a retirement account, which is called a qualified annuity, subject to traditional retirement account rules. For instance, your contributions are tax-deductible up to the annual IRS limit. You defer paying tax on the annuity's earnings until you withdraw after age 59.5 and must take the required minimum distributions at age 72 or 73.
When you own an annuity outside of a retirement account, it's called a non-qualified annuity, and you only have the option to contribute after-tax dollars. As I mentioned, there are no annual contribution limits, so you can invest as much money as you like.
Even though you pay tax upfront on contributions to a non-qualified annuity, you defer paying tax on investment earnings until you withdraw after age 59.5. And unlike a qualified annuity, you don't have to start taking distributions at any specific age.
So you don't get as many tax advantages with a non-qualified annuity; however, it doesn't come with as many restrictions.
Can You Tap an Annuity Early?
Even if you don't own a tax-deferred annuity inside a retirement account, it still acts a bit like one. For instance, you enjoy tax-deferred growth until you withdraw after age 59½.
However, taking an early withdrawal from an annuity is typically subject to income tax plus a 10% penalty. As I previously mentioned, some annuity providers also charge an additional penalty, a surrender charge, for taking an early withdrawal.
What Is an Annuity Rider?
Similar to adding a rider to a home insurance policy to protect valuable jewelry, you can add a rider to an annuity and receive optional benefits for an added cost. A few annuity riders include:
Why are Annuities Controversial?
Marsha mentioned that experts seem to love or hate annuities. I believe that you should be somewhere in the middle. Annuities can be a terrific addition to your portfolio, depending on your assets, goals, and risk tolerance.
For instance, if you don't have much saved, don't qualify for Social Security, or are worried about outliving your money in retirement, annuity payments guarantee you an income for life. What's not to love about that?
With stock market investments, you may receive higher returns than an annuity, but market returns are never guaranteed. So, owning one or more annuities ensures you survive a long retirement even if the market drops. As I said before, the purpose of an annuity is to shift the risk of losing money or running out of money to an insurance company–not to earn the highest possible return.
In addition to knowing your annuity income won't decline, you'll never have to manage complex investments if your cognitive abilities decline in old age. A simple financial situation where you receive a monthly check can comfort a retiree and their family.
However, a downside to the financial security of annuities is that they charge annual fees to cover costs, including a salesperson's commission. Plus, in exchange for guaranteed income, an annuity limits your potential growth in the market.
If you buy an annuity and live a long life, you'll get a great bargain, no matter the fees. But if you live a short time after annuitizing, the insurance company typically wins–unless you opt for a death benefit rider. Remember that annuities are the opposite of life insurance, which benefits when you live a long time.
The bottom line is that annuities can be a terrific addition to your portfolio if you want the simplicity of guaranteed monthly income, no matter the opportunity cost. Since there's a lot to consider regarding annuities, such as taxes, estate planning, and riders, please consult a qualified financial advisor about whether they fit your retirement strategy.
Marsha, you likely don't need an annuity if you have a large nest egg and aren't worried about ever running out of money, no matter your lifestyle or health status. But if you want the peace of mind of guaranteed income immediately after retirement or sometime in the future, I recommend purchasing an annuity with a portion of your investment portfolio.
Carefully review the pros and cons of different annuities and riders with your advisor, and consider getting a second or third opinion if you're unsure about the annuity type or amount that's best for your needs.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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