Personal Capital Tax Series – 5: Is an Annuity Right for You?

March 20, 2017 in Financial Planning by

If you could purchase one product that promised to give you a steady income for life and take the worry out of outliving your assets, would you jump at the chance? While it sounds like an easy decision, this type of product, called an annuity, may not be appropriate for everyone.

An annuity is an insurance contract that is typically used to provide a guaranteed income for life. In the world of finance, however, “guarantees” usually carry hefty price tags, and annuities are no exception. You should fully understand the pros and cons of this product before you decide whether an annuity is right for your investment portfolio. (It may be in your best interest to consult a fiduciary financial advisor before purchasing one of these.)

Types of Annuities

There are many different types of annuities that come with myriad options, riders, disclaimers, footnotes and contingencies.

There are many different types of annuities that come with myriad options, riders, disclaimers, footnotes and contingencies. A financial professional can comb through all the details to help avoid any big pitfalls, as they do get very complicated. Make sure the person you are speaking with is a true financial advisor and not and insurance representative.

The two basic types of annuities are immediate annuities and deferred annuities. An immediate annuity will begin providing an immediate income stream, but you’ll need a lump sum up front to pay for this product. A deferred annuity is more commonly sold to investors who are saving for a future retirement.

Annuity Subtypes

The income you receive depends on the annuity subtypes you choose. Three common options are fixed annuities, variable annuities, and indexed annuities.

If you own a fixed annuity, the insurance company sets a fixed interest rate that is paid on the money you put into it. A variable annuity means money will be split into sub-accounts (depending on your risk level) and invested in stocks, bonds and other investments. In both cases the level of your income depends on the value of the annuity once you start to annuitize. In a fixed annuity, your income will not likely change; in a variable annuity, your income will have a minimum amount and could potentially increase if the sub-accounts perform well. (In many cases this doesn’t happen because the sub-accounts would have to outperform what you withdraw as well as the costs of the annuity.)

Indexed annuities are a cousin of the variable annuities, but their performance is linked to an index and they usually force you to hold on the annuity for a longer period.

Annuity Advantages

For risk-averse investors, annuities can be reassuring. Locking in an income stream and skipping the worry of outliving your assets is appealing to many. You can also make unlimited contributions, unlike tax-advantaged retirement accounts.

Annuity Disadvantages

There are many drawbacks to annuities. Some of these include the fact that annuities are costly; the list of fees associated with them is lengthy. You usually face penalties if you withdraw money early. Additionally, annuity earnings are taxed as ordinary income when you start drawing payments, which could be a significant issue depending on your future retirement income level.

The Takeaway

It’s important to keep in mind that by buying an annuity, you are signing a contract with an insurance company to make payments for a period of time or for your lifetime. The insurance company can make changes to the interest they pay, returns, investment options and payouts. Locking your money up for a long time will take away flexibility and it’s important to think through what your true needs are.

Confused about annuities? Download the free “Tax Report for Holistic Financial Planning” for more details about annuities, as well as other tax tips about education savings, healthcare, retirement more. For more questions about your long-term financial goals, schedule a free appointment with an advisor today.

This blog is for informational purposes only; we are not in the business of providing tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.

Next Up: Deductions & Credits

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Amin Dabit, CFP®

Amin Dabit, CFP®

Amin Dabit is a Senior Vice President and Financial Planning Manager with Personal Capital. Along with the EVP of Portfolio Management, Amin helps lead Personal Capital’s financial planning experience and advice. Amin brings over a dozen years of experience in private wealth management and financial planning. Amin works with the advisory team to identify and establish strategies for reaching clients' financial goals by providing comprehensive, customized financial advice designed to improve their financial lives.

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.