Annuities can be a confusing topic because there are different types that can help you accomplish different goals. Because of that complexity, many people miss out on what could be a valuable solution.
1. Not all annuities only guarantee income; some both create income and grow savings
The word annuity is derived from the Latin, annuus, meaning yearly. The original type of annuity guarantees the buyer annual payments for a set period. But income annuities aren’t the only kind.
In contrast, accumulation-building annuities are designed to grow savings for the long term while deferring taxes. With them, you keep control of your money, earn interest, and can pass the funds to your heirs.
These come in different types. Fixed annuities, which include fixed-rate annuities (more on them below) and fixed-indexed annuities, guarantee your principal. Variable annuities are linked to the performance of financial markets and have fewer guarantees, exposing your principal to investment risk.
Of course, the income annuity is still a valuable tool. The most popular type guarantees lifetime income, starting either almost immediately (immediate annuity) or at a future date (deferred income annuity). It provides invaluable “longevity insurance” and helps assure you’ll never run out of money no matter how long you live. Essentially, you’re converting some of your money into your own private pension.
Many independent financial experts say that most people should put a substantial part of their savings into an income annuity when they approach or enter retirement. Income annuities are underused, I believe. But not everyone needs or wants one. If, for instance, you have ample guaranteed retirement income from Social Security and other sources, you may not need an income annuity. You may not like the idea of giving up control of your money to an insurance company in exchange for an income guarantee. In that case, you’d be looking at an accumulation-building annuity.
2. You won’t pay a sales charge
The selling agent earns a commission, but you won’t pay it. The issuing insurance company does. All of the money you deposit in an annuity goes to work for you right away.
Many people don’t believe this, but it’s true. If you ever encounter an agent who would charge you an upfront commission, go elsewhere.
You might pay a fee under a couple of limited circumstances. If you surrender your annuity early or take excessive withdrawals during the surrender period, the insurer will hit you with a surrender penalty. Therefore, don’t put money in an annuity if you may need the whole amount before the contract is up. Most annuities do permit partial withdrawals annually up to a certain limit, so there is usually some liquidity. However, any earnings withdrawn from a nonqualified annuity before age 59½ are normally subject to income tax plus a 10% IRS penalty.
If you choose an optional rider—an add-on that provides additional benefits such as increased liquidity or guaranteed lifetime income—the fee for it will typically be deducted from your annuity account value annually, or you’ll earn a slightly lower rate.
3. The interest rate can be guaranteed for up to 10 years
A traditional fixed-rate annuity pays a set interest rate that’s usually guaranteed for just the first year. After that, you’re guaranteed only a minimum rate as specified in the contract. So, potentially, the insurance company could take advantage of you in subsequent years because you are locked into a long surrender term and would have to pay a substantial fee to surrender the contract and earn a better rate elsewhere.
But this approach is rarely used now. Instead, you can guarantee the interest rate from three to ten years. That’s why this product is called a multi-year guaranteed annuity (MYGA).
It’s also sometimes called a CD-type annuity because it behaves much like a bank CD. For instance, you can choose one that guarantees 5.26% for five years (as of September 2024). Unlike a CD, a nonqualified annuity is tax-deferred, as long as the interest earnings are not withdrawn.
Current rates are historically high, so it’s a good time to consider a MYGA.
4. There are no government-imposed limits on how much you can put in a nonqualified annuity
Qualified retirement plans such as IRAs, Roth IRAs and 401(k) plans have limits on the amount anyone can contribute annually. The law places no limits on the amount of nonqualified funds you can allocate to annuities.
If you can afford to place a big lump sum in an income or accumulation-building annuity, you’re free to do so. You don’t have to spread out your deposits over the years.
A nonqualified deferred annuity is tax-deferred by design. Earnings compound free of federal and state taxes until they’re withdrawn, and withdrawals aren’t required. If you don’t need the income, withdrawals can be postponed indefinitely.
The exception to this is an immediate-income annuity, where you’ll get some ongoing taxable income along with tax-free return of principal.
5. Annuities can work well in an IRA or Roth IRA
Since annuities provide tax deferral, it may seem redundant to use them in a tax-deferred retirement plan. But an annuity can work well within a qualified plan, particularly an IRA or a Roth IRA. They’re especially apt for people in their 50s and older.
A MYGA can be an excellent substitute for bonds. The guaranteed rate of three to ten years can be matched to your time horizon and usually exceeds the rates on available bank certificates of deposit or individual bonds. Bond funds, in contrast, don’t offer a guaranteed rate of return. If rates spike, you can lose money.
A fixed-indexed annuity offers market-based growth potential while still guaranteeing your principal. They pay a share of the gain as an annual interest rate credit when the stock market goes up. In exchange for the guarantee that you’ll never lose money, you may get only part of the market’s annual gain as measured by an index such as the Dow Jones Industrial Average or S&P 500. If the market index is negative for the year, you’ll typically get no interest.
These complex products are meant for the long term, that’s one reason why they can work well as IRAs.
You must start taking RMDs from your IRA, 401(k) plan or other qualified retirement plan when you reach age 73. You can defer some RMDs by placing some of your IRA assets in a qualified longevity annuity contract (QLAC). The money in one is excluded from plan assets on which RMDs are calculated.
A type of deferred lifetime income annuity that meets IRS requirements, a QLAC lets you keep more of your retirement plan intact and tax-deferred longer. Under the SECURE 2.0 Act, an individual can place up to $200,000 in a QLAC IRA. You must start taking income payments from a QLAC at 85 but may begin sooner.
To purchase a QLAC, you can transfer funds from your IRA, 401(k) or another eligible retirement plan to the issuing life insurance company. This single deposit funds the QLAC. Because the funds are going from one plan custodian to another, it’s a tax-free transfer.
A QLAC cannot be used as a Roth IRA, but other types of annuities can. Besides using a MYGA or fixed-indexed annuity, you could put some or all of your Roth IRA money into a lifetime deferred or immediate annuity and receive lifetime guaranteed tax-free income.
With annuities, what you don’t know can hurt you. They’re one of the mainstay financial products that everyone should know something about.
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Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.