What You Need to Know About Annuities

If you are thinking about adding an annuity to your investment portfolio, be sure you know the facts, ask yourself and your financial advisor the right questions, and consider all options, risks, benefits, and consequences of your decision.

Know the Facts

An annuity is an investment product purchased from an insurance company that provides guaranteed, systematic payments. These payments can occur now or in the future, depending on the terms of the annuity you purchase.

In general, you will find three different types of annuities. Fixed annuities have a guaranteed payout in addition to a guaranteed rate of return. Variable annuities do not offer a fixed rate of return; rather, your rate of return will depend upon the performance of the funds in which you invest your money, whether bonds, stocks, or mutual funds. Finally, equity-indexed annuities guarantee a minimum interest rate, with which is combined a variable interest rate dependent upon the performance of a market index, such as the S&P 500. All annuities have two phases: (1) the accumulation phase, during which you contribute to the annuity and your contributions and earnings accumulate, and (2) the distribution phase, during which you receive your funds (this can be either through a lump sum distribution or through systematic payouts).

While annuities have many things in common with mutual funds, they offer additional advantages, for example, annuities offer tax-deferred earnings, a guaranteed lifetime income, and a death benefit.

Know What Questions to Ask

Before purchasing an annuity, make sure you are in it for the long haul. Annuities best serve long-term goals and are not appropriate for short-term saving. In addition, surrendering an annuity early can cost you loads in fees and penalties.

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Make sure that you will benefit from an annuity in tax terms. For example, if you already have a work-related retirement plan or an IRA, you will not receive further tax-deferral benefits from an annuity.

Be certain that you understand the function, terms, and costs of an annuity before you make your purchase. Consider any fees or other expenses the annuity might charge. Talk with your financial advisor about the tax consequences of purchasing an annuity (will your taxes increase in retirement)? If the annuity you are considering offers a bonus credit, be sure that the credit will set off any increased fees.

If you already have an annuity and are considering a 1035 exchange, be certain that the costs of the exchange will be covered by any gains you hope to make.

Know Your Risks, Benefits, and Other Options

You might have other investment options at your disposal, such as your IRA or 401(k), which will also give you a tax-deferred status on your earnings. Before you invest in an annuity, it might be advantageous to maximize your IRA and 401(k) contributions. Remember that by investing in an annuity through another retirement program, you will not gain additional tax advantages with the annuity.

Remember That Annuities Are Not Risk-Free

Before purchasing additional benefits with your annuity, weigh the costs. Consider if you really need the benefit, and if you do, check the cost of purchasing the benefit separate from the annuity.

If you are planning to purchase a new annuity for a 1035 exchange, make certain that you compare both the new and the old annuity with care. If the new annuity will reset your surrender period, you might want to consider keeping the old annuity. Also, make sure that your exchange will not incur taxation. Do not surrender your old annuity in order to buy a new one, or taxes will be a definite burden.