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What Are Annuities?

Nov 09, 2021 4 min read Miranda Marquit

Key takeaways

  • An annuity can provide predictable, guaranteed income in retirement.
  • You can use tax-advantaged dollars to fund an annuity.
  • Review your choices to figure out whether an annuity is right for you.

 

As they approach retirement, many people worry about whether they’ll have income they can count on the rest of their life. One way to secure a lifetime source of income is to buy an annuity. These work differently from retirement accounts such as IRAs and 401(k)s. (Indeed, portable workplace plans like 401(k)s—which you can take with you if you leave your job—rarely offered annuities in the past. But 2019’s federal SECURE Act made it easier for employers to offer them, and a growing number have begun to do so.)

So, what exactly are annuities, and how do they work? Let’s take a closer look.

 

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How do annuities work?

Annuities are long-term investments designed to provide you with guaranteed income for the rest of your life. When you purchase an annuity, typically from an insurance company, the provider invests the money with the goal of gaining in value over time. When the funds annuitize, they begin to convert into regular payments to you. Depending on the kind of annuity you have, you’ll get payments for either a set period or the rest of your life (like Social Security). This steady income stream can help you budget and cover expenses in retirement.

Before you buy, it’s important to understand the tax implications, as well as events that can reduce the annuity’s value (and your eventual payments). For example, different annuities may have different rules for survivor benefits or for what happens if you start taking payments before the date set in the contract.

Also, an annuity’s guarantees are backed by the company that issues it. So, consider whether that company has staying power—and read (and understand) the fine print—before you buy.

 

Types of annuities

Different kinds of annuities have different characteristics. When choosing the one you want, it’s important to consider your goals and needs.

 

Fixed vs. variable

  • A fixed annuity guarantees your principal and offers a stated rate of interest during a set period of time.
  • A variable annuity is based on the performance of the stock market; its gains (and your potential payout) depend on how its investments perform.

Essentially, a fixed annuity provides you with more certainty: You can be reasonably sure of your payments when the time comes. By contrast, a variable annuity can generate higher gains but also involves more risk and uncertainty, especially when the investment market is volatile.

 

Deferred vs. immediate

  • A deferred annuity is one you purchase years before you plan to retire. You can usually set up a regular contribution schedule so you can pay into the annuity over time until you’re ready to retire and take payments.
  • You typically buy an immediate annuity with a single, lump sum amount when you want to begin receiving payments right away (or at least soon).

Some retirees withdraw a portion of their tax-advantaged retirement accounts and use the money to purchase an immediate annuity. This way, they can begin getting the cash flow they need to cover retirement expenses.

 

Are annuities taxable?

In general, some portion of your annuity payout will be taxable. However, the way the money is taxed depends on how you fund the annuity:

Qualified vs. nonqualified

  • You fund a qualified annuity with pretax dollars. For example, if you use money from a traditional 401(k) or IRA to buy or add to the annuity, it’s considered qualified. The earnings and interest from the annuity are tax deferred, but withdrawals are taxable.
  • A nonqualified annuity is funded with after-tax dollars. It’s money you’ve already paid taxes on and that isn’t in a tax-deferred retirement account.
  • An annuity funded with after-tax Roth dollars—whether from an IRA or workplace retirement plan—also can grow tax deferred, but withdrawals are tax free if you meet certain criteria. This type of annuity is neither qualified nor nonqualified.

Payments from a qualified annuity are taxable at your regular income rate when you receive them. But payments from a nonqualified annuity are treated differently: You generally owe taxes only on the earnings portion of your payments. (The amount is determined using a formula called an “exclusion ratio.” It compares the percentage of payments that came from the pretax amount used to buy the annuity with any earnings, along with your life expectancy. If you live beyond your expectancy, your remaining payments become fully taxable.)

Note that if you fund an annuity with money from a Roth account (pretax investments with potentially tax-free withdrawals), your annuity payments could also be tax free. Check with a knowledgeable tax professional to review your situation.

 

Are annuities a good investment?

Whether an annuity is right for you depends on your needs and retirement goals.

In some cases, an annuity can make sense if you want regular, predictable payments to help cover expenses during retirement. (Keep in mind that you don’t have to use your entire retirement account to purchase an annuity. Instead, you can use some of it to buy an annuity that can meet your basic needs, and keep the rest in the account for future growth and to cover extras.)

Also, because some annuity contracts are complicated and come with exclusions, limitations, benefit reductions and fees, it’s important to run the numbers carefully. A trusted financial professional can help you learn the details and determine whether an annuity is a good choice for you.

 

What you can do next

Speak with a financial professional about your long-term retirement goals. If it makes sense to include annuities in your retirement strategy, ask the adviser about what types of annuities are likely to help you reach your goals.

Footnotes

 

Miranda Marquit, MBA, has been covering a variety of personal finance topics for nearly two decades, contributing to a variety of outlets, including NPR, Marketwatch, Yahoo! Finance and HuffPost. In addition to writing about finances, she co-hosts a podcast at Money Talks News.

Prudential annuities are issued by The Prudential Insurance Company of America, Newark, N.J., and its affiliates. Prudential does not provide tax advice; please consult your own attorney or accountant.

 

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