Annuities are a form of insurance contract that allow investors to plan for retirement. There are different types, each of which has its own potential benefits or drawbacks. People who purchase annuities generally have one of two goals: to build a savings account for retirement or to secure a fixed amount of income for the remainder of their lifetime.
A fixed annuity is similar to a certificate or certificate of deposit. A lump sum premium is paid to the insurance company and is guaranteed to grow at a specific rate. Because the rate is fixed, the earning potential is less than something more risky. Fees are deducted from the account and any earnings your money receives beyond the guaranteed rate are absorbed by the insurance company. You also won’t have to pay taxes on the earnings until you withdraw.
A variable annuity is in many ways similar to an Individual Retirement Account (IRA). The earnings are tax deferred, meaning taxes are not paid on what the account earns until you start withdrawing funds. This can be an advantage in the variable annuity because the account may grow more quickly with compounding earnings.
Another potential advantage is being able to shift money between investment options without paying taxes on earnings. Because this is an insurance contract, there may be higher fees and costs associated with maintaining the plan which could outweigh the tax benefits for compounding earnings. As with most investments, there is also a risk that the account could lose value.
An income annuity guarantees a fixed amount of income monthly for as long as the beneficiary (person designated to receive the money) lives. The income could begin immediately or at a set date in the future. This type of annuity requires a lump sum of money be used to purchase the annuity. A possible advantage is the guarantee of a specific amount of money every month, regardless of what happens with the stock market or other investments.
Additionally, it eliminates the risk of running out of money based on how long you live. A potential disadvantage is having to come up with the money all at once. The purchaser will no longer have access to the money used to purchase the annuity, aside from the fixed monthly income. This could be problematic in the case of emergencies or unexpected life events.
For more comprehensive information, check out the sources for this article: investopedia.com and money.cnn.com.