When I mention annuities as a potential investment vehicle, I usually get one of two typical responses from clients. I either hear “What is an annuity?” or “A friend told me annuities are a bad investment.” In my findings, annuities turn out to be widely misunderstood. What’s more, they may be a good fit for some investors. Like other investment options, annuities help serve a specific purpose and client base.

What is an annuity?

Annuities are a contract between you and an insurance company in which you make a lump-sum payment or series of payments, and in return, receive regular disbursements. These disbursements begin either immediately – referred to as an “immediate annuity” – or at some point in the future – referred to as a “deferred annuity.”

How do annuities work and when should you use an annuity?

There are multiple situations in which it makes sense for an investor to choose an annuity, and one common scenario is an individual preparing to retire but does not have a traditional retirement savings account, such as a 401(k) or IRA, but does have a lump sum amount of cash and would like a steady stream of guaranteed income in retirement.

Take this example of Jane Doe, an individual preparing to retire but has no 401(k) or pension plan due to being self-employed during her career. Jane wants to receive regular income during retirement but does not want to file for Social Security yet, so Jane is investing in an annuity.

Jane works with a financial professional to assess her lump sum of cash savings and determine the monthly amount she could receive for the rest of her life. After running insurance annuity quotes which consider Jane’s life expectancy, Jane finds out that if she invests her lump sum of $250,000 in annuity, she will be guaranteed a paycheck of $1,000 per month for life.

In the event of death, insurance companies often offer options called “period certain” or a “refund/installment” option that allows remaining funds in an annuity to be passed on to beneficiaries. For example, if Jane invested her $250,000 and took advantage of the insurance company’s refund/installment options and then died unexpectedly after taking only a few months’ worth of payments, her beneficiaries would be entitled to the remaining funds. This is one reason it is essential you work with a trusted financial professional who is knowledgeable about these options and can help you work towards your financial needs during your lifetime and after.

What you should keep in mind

There are several advantages and disadvantages to annuities, and it’s important you keep them all in mind as you determine if they are a good fit for your specific financial situation and needs. Here are a few topics to discuss with your trusted financial professional.

Access to funds

One disadvantage of annuities is that most insurance companies do not allow you to access your funds once you annuitize. Therefore, it is important to ensure your financial professional is aware of your liquidity needs and you build a solid emergency fund in the event you need access to money.

Tax benefits

One advantage of annuities is that they may also be a good fit for individuals who are not looking for a regular income stream but would like to take advantage of some of the tax benefits of annuities. Annuities can be used as a vehicle to grow funds on a taxed deferred basis, similar to an IRA’s tax deferral feature. This may be especially attractive to investors who typically rely on CDs but find the current rate is low, and investors who are hesitant to heavily invest in the stock market given its recent volatility.

Different types of annuities

There are different types of annuities, including:

  • Fixed annuities, which are similar to CDs in that they come with a fixed rate and fixed term determined by the insurance company and cannot change or fluctuate during the term.
  • Fixed indexed annuities, which allow you to participate in market growth like the S&P 500 up to a certain percent, but if the market is down, you do not lose any of your principal.
  • Variable annuities, which are the most aggressive and risky, as they are tied to subaccounts that act similarly to mutual funds and involve the risk of losing principal.

At the end of your annuity term, you can either renew it with the company or move it elsewhere. It is always a good idea to consult with a tax professional prior to doing so, as gains are not treated the same as typical investment gains. If you are not yet aged 59 and a half, you should also be careful to avoid a 10% penalty if you cash out. Due to the tax deferral feature, you must be 59 and a half or older to cash out an annuity and avoid this penalty.

The bottom line

Annuities, like all investment products, serve a purpose and are suitable for certain situations. By working with a trusted financial professional, you can determine if an annuity is suitable for you. Ensure your financial professional understands your holistic financial picture and your unique investment needs in order to find the best products for you.

Next steps:

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Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Optional riders have limitations and are available for an additional cost through the purchase of a variable annuity contract. Guarantees are based on the claims paying ability of the issuing company.

The options mentioned in this article should not be received as direct investment advice. Please seek the advice of a trusted investment professional to ensure any investment is tailored to your unique financial situation.

Bailey Davis is a Financial Advisor with Securities America Advisors, Inc. Securities offered through Securities America, Inc., member FINRA/SIPC. Bankers Trust, BTC Financial Services, a division of Bankers Trust, and Securities America are separate companies. Not FDIC Insured. No Bank Guarantees. May Lose Value. Not a Deposit. Not Insured by Any Government Agency.

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