Some people find annuities difficult to understand. This can be due to the many different types of annuities or the fact that they are so unique compared to other types of investments. People just haven’t encountered anything like them.
However, if you need additional income for retirement, an annuity might be exactly what you need.
Don’t let initial confusion keep you away from investigating further. Understand these two essential facts about annuities, and you will have a good understanding.
1) Annuities have early withdrawal penalties.
Insurance companies issue annuities and each company has different penalty rates for early withdrawal. However, the penalty tends to average 7% across all companies.
But 7% is usually only in the first year of the annuity contract and typically drops 1% each year.
Once the contract term of your annuity has expired (it may be 5, ten years) you can withdrawal your funds without penalty.
It’s no different than facing penalties if you withdraw funds from a 401(k) or IRA before age 59-1/2.
Some exceptions allow you to withdraw your funds before the annuity term has expired. If you become permanently disabled or, worse, pass away, your funds can fully be cashed out without penalty.
But, here’s a way to potentially avoid penalties: You can withdrawal 10% of your annuity’s value annually without paying surrender fees. If you do need to begin withdrawing your funds, this may be a good option.
Also, all annuities come with a ‘grace period.’ If you purchase an annuity and decide within 30 days an annuity is not right for you, you will pay no surrender fees to withdraw your funds. (This grace period can vary by insurance company).
Each annuity is different. Understand the contractual obligations of the annuity you purchase beforehand. If you’re somebody who requires a more liquid investment or you’re not sure you can adhere to a term, consider other options. But if income that you cannot outlive is necessary, and safety and security are important, and freedom from worry and stress is important, an annuity could be the best possible choice.
2) Annuities have different tax implications
With 401 (k)s and IRAs, you get a tax break right away. You can deduct the amount you put into an IRA account from your tax returns. With a 401 (k) you instruct your employer how much to take out of your paychecks and use that money to fund your account.
With annuities (purchased outside an IRA) you cannot deduct them on your tax return. But the good news is that you don’t pay taxes as the value of your annuity grows. Annuities are tax-deferred. You will not pay taxes until you begin taking withdrawals. You must also pay taxes on a traditional 401 (k) or an IRA, but annuities are a bit different.
With an annuity, you pay taxes on the ‘growth value’ of your annuity, not the amount you put in.
So, for example, if you put a $100,000 into an annuity and it grew to $250,000, you will only pay taxes on the $150,000 in growth.
If you withdrawal your annuity in payments, a portion (growth value) will be taxed, and the initial investment portion will not be.
These are two annuity basics that have hopefully given you some clarity. It’s important to talk with a financial professional to see if an annuity is correct for your situations. Understand the pros and cons and make an educated decision before purchasing an annuity.