In addition to Social Security, 401(k) savings and pensions, annuities can provide an important source of monthly income that many retirees rely on, and they offer the flexibility to decide when to start taking distributions, if needed.
An “annuity” is a contract with an insurance company. You invest in an annuity in a series of payments or a lump sum. When you’re ready, the insurance company provides you with a steady cash flow for a specific period of time. People often invest in annuities to reduce the risk of running out of savings after retirement.
TD Bank offers some important facts to consider when investing in annuities.
There are different types of pensions
There are several types of annuities, each with their own unique features and benefits to consider. The three most common types are:
- Fixed Annuity – A fixed interest rate set by the insurance company is paid over a set period of time (usually 3-7 years).
- Indexed Annuities – Instead of a fixed interest rate, you earn interest based on the performance of a specific market index, such as the S&P 500. The minimum return that insurance companies set on indexed annuities is 0%, so even if the S&P 500 goes negative that year, you won’t lose money. Insurance companies usually also put a cap on the “upside” so if your cap is 5% and the S&P 500 goes up 8%, you’ll only make a 5% gain.
- Variable Annuities – Your money is invested in a portfolio of mutual funds within an annuity product. Returns are not guaranteed and the value of the annuity may decline. Performance depends on market performance. Larger gains or losses are possible than with fixed or indexed annuities.
Your money grows tax deferred
While the money is in the annuity, the interest grows tax-free, which means you don’t pay tax on the interest until you withdraw the money from the annuity. So you get interest on your money, interest on the interest, and interest on the money you would have paid in tax.
Annuity distributions are taxed differently depending on how you deposit funds into the account. Annuities can be deposited with either pre-tax or after-tax funds. These are called qualified or non-qualified annuities.
A qualified annuity is funded by pre-tax contributions, usually from an IRA or 401(k). Distributions from a qualified annuity are taxed when you take the distributions.
Nonqualified annuities are funded with after-tax contributions, usually made from a checking or savings account. Taxes on distributions from a nonqualified annuity generally only apply to the interest earned.
You must designate a beneficiary for your pension
An important thing to consider with annuities is that you must name a beneficiary for your annuity. Upon your death, your existing death benefit will be paid directly to your beneficiary, allowing them to receive your assets without the expense and delays of probate.
Pension risk
Fixed and indexed annuities are generally considered “low risk,” although the degree of risk varies by annuity type. Annuities are long-term investments, and early withdrawals (before the end of the term) can result in surrender charges. Because annuities are given tax benefits for retirement planning, there is currently a 10% IRS penalty on any money withdrawn before age 59 1/2. For this reason, annuities are generally recommended for people over the age of 50.
Although annuities are offered by licensed insurance professionals at many banks, it is important to keep in mind that they are not bank products and are not guaranteed by banks. Annuities are issued by insurance companies and are not insured by the FDIC. They may also lose value.
Before investing in an annuity, it pays to speak with a financial advisor, who can help you choose an annuity based on your risk tolerance, investment time horizon, financial needs and other factors.
You should also have an emergency fund
As mentioned above, annuities are long-term investments, and early withdrawals can incur surrender penalties. Additionally, if you invest all of your retirement savings in an annuity, you may not be able to withdraw enough money to cover unexpected expenses like car repairs, medical bills, or home maintenance, and you could be subject to penalties and surrender charges. Therefore, it is important to have an emergency fund set aside in case you need money in the short term.
This story It was produced by TD Bank Reviewed and distributed by Stacker Media.
