What to Consider when Buying an Annuity

Annuities can be a valuable tool in retirement planning, offering the potential for steady income streams and financial security in your later years. But with various types, rules, and fees to consider, it’s crucial to understand how annuities work before committing. A few things to consider about annuities include:

• Fees and potential costs
• Taxes
• Payout options
• Liquidity needs

Whether you’re new to annuities or exploring ways to diversify your portfolio, this guide will help you understand the key factors to consider before buying an annuity.

What is an annuity?

For starters, an annuity is a financial contract that allows you to invest a sum of money in exchange for periodic payments over a set period, often during retirement. These payments can provide a reliable source of income, potentially lasting a lifetime, depending on the terms. While annuities can play a role in providing security, they come with complexities such as fees, withdrawal rules, and tax implications.

Annuities are generally purchased through insurance companies or financial institutions, and they are structured either as fixed or variable. The choice between these two types depends on your financial goals, risk tolerance, and expectations for income. Understanding the benefits of each type, and when to choose which, is crucial to making the right decision for your financial future.

What is a fixed annuity?

A fixed annuity is the most straightforward form of annuity. It provides a guaranteed payment amount over time, which means you know exactly how much you’ll receive at each payout. Typically, fixed annuities are more conservative investments that appeal to those looking for financial stability and predictability in retirement. These annuities are not tied to market performance, making them attractive to risk-averse investors.

In addition to steady payments, fixed annuities often include benefits like tax-deferred growth on the invested amount. This means the money in your fixed annuity grows without being subject to taxes until you start receiving payments. Furthermore, they can offer a range of payout options, from periodic payments over a set number of years to lifetime income streams.

However, while these benefits provide security, the trade-off is usually a lower return on investment compared to more growth-oriented options.

What are variable annuities?

Variable annuities differ from fixed annuities in that their payouts depend on the performance of investments selected within the annuity. With variable annuities, your payments fluctuate based on how the underlying investments (such as stocks and bonds) perform. This makes variable annuities riskier than fixed ones but also offers the potential for higher returns.

These annuities are typically suited for individuals comfortable with some degree of market risk and those looking to grow their income through investments. The trade-off, however, is that your payments are not guaranteed, and in down markets, your income could be significantly lower than expected.

It’s also worth noting that variable annuities often come with higher fees, including management fees and potential surrender charges if you withdraw funds too early.

What should I know before buying an annuity?

Before purchasing an annuity, there are several important factors to consider:

Know what fees to expect

Annuities are often associated with a variety of fees that can impact the overall returns on your investment. These fees are typically higher than those associated with other investment products, so it’s essential to be fully aware of them before committing.

• Administrative fees: Most annuities come with administrative fees that cover the costs of managing and servicing the contract. These can range from 0.1% to 0.5% of the annuity’s value annually, which can add up over time, particularly if you hold the annuity for many years.
• Surrender charges: If you decide to withdraw money from your annuity early, you may face surrender charges. These are penalties imposed by the insurance company for withdrawing funds before a specified period, often ranging from 5 to 10 years. Surrender charges can be steep, sometimes as high as 7% of the withdrawal amount, and they usually decrease over time.
• Mortality and expense fees: Variable annuities often include mortality and expense fees, which compensate the insurance company for the risk it takes in providing you with lifetime income. These fees typically range from 1% to 1.5% of the annuity’s value annually.
• Rider fees: Many annuities offer optional features, called riders, that provide additional benefits, such as guaranteed income for life or protection against investment loss. While these riders can be useful, they come at an additional cost. Rider fees can range from 0.5% to 1% or more of the annuity’s value, depending on the specific rider.

Because annuities often carry a higher fee structure than other retirement investment vehicles like mutual funds or exchange-traded funds (ETFs), it’s important to compare the costs and understand how they will affect your returns over time. In some cases, the guarantees and security that annuities provide may be worth the fees, but always evaluate whether the cost aligns with your retirement goals.

Consider tax obligations

Is an annuity taxable? Yes, depending on how they are structured and funded. Annuities are often praised for their tax-deferred growth, but it’s important to understand how they are taxed both during the accumulation phase and when you start receiving payments.

• Tax-deferred growth: One of the primary benefits of an annuity is that it allows your investment to grow tax-deferred. This means you won’t pay taxes on the earnings within your annuity until you begin making withdrawals. However, unlike investments in a Roth IRA or Roth 401(k), the withdrawals you make from an annuity will typically be taxed as ordinary income rather than at the more favorable long-term capital gains rate.
• Qualified vs. non-qualified annuities: If you purchase an annuity through a tax-advantaged retirement account, such as an IRA or 401(k), it is considered a qualified annuity. In this case, both the contributions and the earnings will be taxed as ordinary income upon withdrawal. On the other hand, if you purchase an annuity with after-tax dollars (non-qualified), only the earnings will be subject to tax, while your original principal is returned tax-free.
• Early withdrawal penalties: Withdrawals made from an annuity before the age of 59½ may be subject to a 10% early withdrawal penalty from the IRS, in addition to ordinary income tax. This is similar to the early withdrawal penalties for other tax-advantaged retirement accounts.
• Taxation of payments: When you start receiving payments from your annuity, the tax treatment will depend on whether it was purchased with pre-tax or after-tax dollars. For qualified annuities (funded with pre-tax dollars), all payments will be taxed as ordinary income. For non-qualified annuities (funded with after-tax dollars), only the earnings portion of each payment will be taxed, while the portion representing your original investment will be tax-free.

Understanding the tax implications of an annuity is critical because the timing and nature of your withdrawals can have a significant impact on your overall tax liability in retirement. It’s often helpful to coordinate your annuity withdrawals with other income sources to minimize tax exposure.

Know your payout options

Annuities come with several different payout options, allowing you to customize how and when you receive income. Choosing the right payout option is essential for ensuring that your annuity aligns with your financial needs and retirement goals. Some of the most common payout options include:

• Life-only payments: With a life-only payout option, you will receive regular payments for the rest of your life. These payments typically end when you pass away, which means that there is no benefit left for your heirs. Life-only payments often provide the highest payout amounts because they are based solely on your life expectancy.
• Joint and survivor payments: This option allows you to continue providing income for your spouse after your death. The payments may be reduced to a certain percentage (such as 50% or 75%) for the surviving spouse, depending on the terms of the contract. Joint and survivor annuities are popular among couples who want both individuals to have a steady source of income in retirement.
• Period-certain payments: If you want to guarantee payments for a specific period, such as 10 or 20 years, you can choose a period-certain payout option. If you pass away before the end of the term, your beneficiaries will continue to receive payments for the remainder of the period. This option is useful for those who want to provide a legacy to their heirs while still receiving regular income.
• Lump-sum payment: Some annuities offer the option to receive a lump-sum payment instead of regular installments. While this can provide immediate liquidity, opting for a lump sum may result in a significant tax hit, and you will lose the benefit of guaranteed income over time. A lump-sum payment may be ideal for those who prefer to manage their own investments or have other income sources in place.

When considering the payout options, it’s important to think about your long-term financial needs and how the annuity fits into your overall retirement strategy. Life expectancy, the need for liquidity, and whether you want to leave a financial legacy to your heirs are all critical factors to weigh when deciding how to receive your annuity payments.

What are the “don’ts” of annuities?

Knowing what not to do is often just as important as knowing what to do with annuities. In that spirit, here are some things not to do when it comes to annuities:

1. DON’T consider an annuity without understanding the product fully. Annuities can be complicated, with many different types and features, so it’s essential to take your time and ask questions. Don’t rush into an annuity purchase because you’re drawn to the promise of guaranteed income — there are often fees, restrictions, and long-term commitments involved.
2. DON’T buy an annuity without considering your liquidity needs. Many annuities come with hefty surrender charges if you withdraw money early, which can limit your financial flexibility. It’s also important not to overlook the impact of inflation; fixed payments from a traditional annuity can lose purchasing power over time.
3. DON’T commit to an annuity without reviewing the fees and potential costs. Annuities often come with various fees, including management fees, mortality expenses, and administrative costs, which can erode your investment returns.

Considering buying an annuity for retirement? Let’s talk.

Annuities can offer a reliable source of income during retirement, but they are not without their risks. Before purchasing one, it’s important to assess your retirement goals, liquidity needs, and risk tolerance. Whether you’re looking for guaranteed payments or seeking potential growth through investments, understanding the types of annuities available and how they align with your financial plan is essential.

At Avidian Wealth Solutions, we help individuals evaluate their options for creating a sustainable income stream in retirement. If you’re considering buying an annuity or want to explore how it could fit into your broader retirement planning strategy, let’s discuss your goals. With locations in Houston, Austin, Sugar Land, and The Woodlands, we can help you make informed decisions for your financial future.

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