Planning for retirement involves more than just saving money—it’s about creating a reliable stream of income you can count on for the rest of your life. One way to secure that income is through an annuity. Offered by an insurance company, annuities are financial products designed to convert your retirement savings into regular payments, either immediately or in the future. If you're looking for guaranteed income as part of your financial plan, understanding how annuities work can help you make informed decisions about your retirement strategy.
How Annuities Work
An annuity is a contract between an individual (the annuitant) and a life insurance company. In exchange for a lump sum or series of payments—known as premiums—the insurer agrees to provide income payments either right away or at a future date. This arrangement is intended to offer retirees a steady stream of income, often for a fixed period or for the remainder of their lives.
Annuities typically go through two main phases: the accumulation phase and the payout phase. During the accumulation phase, the annuity grows on a tax-deferred basis, meaning you won’t pay taxes on the earnings until you begin receiving income payments. In the payout phase, you start receiving regular payments, which may be taxed depending on how the annuity was funded (with after-tax or pre-tax dollars).
Types of Annuities
There are several types of annuity products to choose from, each designed to meet different financial goals and risk tolerances.
- Fixed Annuities
With fixed annuities, the insurance company guarantees a specific interest rate and provides fixed, predictable income payments. These are appealing for those seeking stability and a lower investment risk.
- Variable Annuities
Variable annuities offer a wider range of investment options, including sub-accounts tied to mutual funds or stock markets. The payout varies depending on the performance of the underlying investment, which introduces investment risk but also the potential for a higher rate of return.
- Indexed Annuities (Fixed Indexed Annuities)
These annuities are linked to a stock market index, such as the S&P 500. They offer a guaranteed minimum return with the potential for additional gains based on market performance, all while protecting the annuitant from losses during downturns.
- Immediate Annuities
Funded with a single premium or lump sum payment, immediate annuities begin paying out income almost immediately, often within a year. This option suits retirees seeking income right away.
- Deferred Annuities
With deferred annuities, annuity payments begin at a future date, allowing your investment to grow during the accumulation phase. This is ideal for individuals looking to secure future income while continuing to grow their retirement savings.
Annuities and Retirement Planning
Annuities can serve as a powerful tool within a retirement plan, especially for those looking to supplement Social Security, pension income, or other investments. They can also be used in an IRA or other retirement account to offer guaranteed income and reduce reliance on more volatile assets like mutual funds or stock markets.
Some annuity contracts include features like a death benefit, which can provide support to loved ones if the annuitant passes away before the annuity is fully paid out. Others offer options for lifetime income, ensuring payments continue as long as the annuitant lives.
Annuities funded with pre-tax dollars (such as those held in an IRA) will be taxed as ordinary income tax when payments begin. Annuities funded with after-tax dollars will have a portion of each annuity payment considered a return of principal and may be tax-free.
Considerations and Potential Drawbacks
While annuities offer many benefits, it’s important to understand the potential downsides.
- Surrender charges may apply if you withdraw funds early, reducing the liquidity of your investment.
- Depending on the type of annuity, there may be investment risk tied to market performance.
- Early withdrawals before age 59½ may result in an IRS tax penalty in addition to income tax.
- Annuities can be complex, with varying fees, terms, and conditions depending on the provider and contract type.
Before purchasing an annuity, it's important to review the prospectus, consider your financial goals, and consult with a financial professional or tax professional to ensure the product aligns with your broader financial plan.
Getting Started with Annuities
Annuities are designed to help transform your retirement savings into a predictable stream of income—something many retirees rely on for peace of mind. Whether you're seeking fixed annuities for low-risk income or variable annuities with growth potential, there are options to match your unique financial needs.
Mainstar Trust provides custodial services to help you manage your annuity within a self-directed IRA or other retirement account. If you're ready to explore how annuities can support your financial plan, learn more now then contact our team at Mainstar Trust team to get started. We’re here to help you set up and maintain your retirement account with confidence.