If you've ever considered adding annuities to your arsenal of retirement investment planning strategies, you're not alone. Many Americans incorporate these insurance products into their retirement portfolio under the assumption that it simply makes sense to pay out a bit now, so you can get paid later.
While annuities can be a part of your comprehensive financial plan, the rational investor knows that annuities aren't as simple as they seem on the surface — and they may not be quite as "guaranteed" an income source in retirement as some investment professionals would have you believe.
Here's what our retirement planning advisors suggest that you need to know about annuities.
Annuities 101: What Wealth Advisors Want You to Know
On the surface, annuities are pretty simple: You make an investment in an annuity, a.k.a. an investment product offered by an insurance company, and the annuity makes payments to you later. You may choose to receive disbursements monthly, every few months, every year, or simply in one payment. The amount you receive is based on several factors, including your payment period and the type of annuity you purchase.
Let's review the different types of annuities:
Many consider fixed annuities, so-called because they're based on a set or fixed interest rate, the simplest of the three types. And it's not that complicated; you purchase the annuity at a fixed rate, and the insurance company guarantees that you'll receive the principal and the interest back on a planned future schedule or date. One drawback to be aware of: many annuities won't pay out remaining funds to your beneficiaries if you pass away before the contract is up.
In contrast, variable annuities offer a payout based on investment performance — kind of like investing in a mutual fund. Many investors are attracted to variable annuities thanks to a large range of choices and lack of annual contribution limits. But variable annuities often come with high commission fees attached.
Equity-indexed annuities are like hybrids of fixed and variable annuities. While they guarantee a minimum rate of interest, like fixed annuities, they also offer the chance for greater return if the index they're tied to performance. Often, though, insurance companies cap maximum annual returns, so even if your index has a really great year, you'll may get less out of it than you'd expected.
Annuities: Part of Your Comprehensive Wealth Management Plan?
Given these potential pitfalls, it's essential to understand a few other factors about annuities that aren't necessarily common knowledge.
When considering annuities, be sure to ask about associated fees, as they can be some of the highest in the industry. In contrast to mutual funds or ETFs, annuities often pile on additional fees such as mortality, surrender or expense charges, as well as annual fees that average from 1.3 to 3.5 percent. These really add up over time and take away from your return.
Also, with certain annuities is it possible to be locked into them for years and if you withdraw early you may be faced with very steep withdrawal charges.
Now about taxes. You'll want to keep taxes in mind when considering purchasing annuities. When you take disbursements from an annuity, your payouts are taxes as income; that's up to 35 percent in federal taxes. Mutual funds, on the other hand, are taxed as long-term capital gains at no more than 15 percent.
Though annuities do offer the security of guaranteed income in retirement, speak to your wealth advisor to determine if annuities are the right choice for your comprehensive financial plan.