Financial Planning for Geeks

What is an Annuity? And Why Should I Care?

- Investments

It’s been a while since I wrote anything remotely technical…so let’s get back to our regularly scheduled programming. I want to give you an introduction to annuities and some scenarios when an annuity might fit your needs. Spoiler alert: there are tax savings and guarantees involved, so hopefully that’s enough to keep you reading. Trust me; this is scintillating stuff.

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So what IS an annuity? Fundamentally, it’s a contract between you and an insurance company. You put in a lump sum or some agreed-upon deposits over time, and the insurance company provides you with a guaranteed payout of some kind.

I’m going to focus on taxable annuities in this post. You can get IRA annuities, too, but I’m going to keep it simple and assume that you are using after-tax dollars to invest in your annuity. Let’s get deeper into the characteristics of a taxable annuity:

1.       Taxes: the money in an annuity grows tax-deferred, meaning that you don’t pay taxes on the growth in the account along the way. This leaves more money to grow over time.

    a.       Because of this tax benefit, the IRS will charge you a 10% penalty on any withdrawals you make from an annuity before you turn 59½, just like they do with your 401(k), IRA, or Roth IRA. You will also have to pay taxes on the amount you took out.

    b.       When you take money out, you will not have to pay taxes on your deposits, because you contributed after-tax dollars (remember that I’m focusing on taxable annuities here). You DO have to pay regular income tax on the growth in the account when you take it out. This is different from a regular brokerage account, where you will just pay long-term capital gains tax on the growth if you held the investments for over a year. But hey, you got tax deferral in your annuity and NOT in your brokerage account.

2.       Guarantees: there are several options, but annuity contracts generally guarantee a specific payment to you for a specific period, or for as long as you live. It’s sort of like setting up your own pension: you get regular checks after age 59½ to “pay” yourself, and you get to decide how often they send you the checks.

    a.       You can also buy contract riders to guarantee payments over your lifetime AND the lifetime of your spouse or another beneficiary.

    b.       Your income payment can be adjusted if the value of your investments increases, but there is generally a guarantee of some kind (see the Investment section below). You’ll want to ask about that and how it works.

    c.       Remember that the value of your guaranteed minimum payment decreases over time because of inflation. You can buy riders on your contract, to make sure your payment increases over time and hopefully keeps up with inflation.

    d.       There is a guaranteed death benefit associated with an annuity contract, and although it is no substitute for life insurance it’s a nice thing, especially if you have health issues and can’t get life insurance.

3.       Fees: Annuities are sometimes criticized for having high fees compared to other accounts, but keep in mind that no one is guaranteeing anything in your 401(k), IRA, or brokerage account. Not every annuity has every fee, but here’s what to look for:

    a.       Commissions or money management charges: this is the money that goes to the person who sold you the annuity. Commissions are built into the contract and very difficult to parse out, so you will want to ask about that. Money management charges are like the money management fees you would pay a pro to manage your brokerage account. These charges are usually taken out of the annuity every quarter for the life of the contract.

    b.       Investment fees: the investments inside your annuity may also have management fees, to pay the people who manage the funds.  

    c.       Contract, account, policy or administrative fee: there is sometimes a flat, annual fee associated with the administration of an annuity contract.

    d.       Mortality and Expense (M&E) fee: this fee covers the cost of the life insurance and income guarantees in the contract.

    e.       Surrender charges: There is usually a minimal amount you can take out of your contract each year without any charge. But if you take out more than that during the surrender period you will pay a penalty. If there are surrender charges, they start at the beginning of the contract and typically run for 5, 7, 9 or sometimes 10 years and decrease over time. So a 7-year surrender charge schedule could start at 5% of contract value the first year, then go to 4%, 4%, 3%, 3%, 2%, and 1% over the seven years. After that, there is no penalty for taking money out, although withdrawals can impact your guaranteed payment amount.

    a.       Rider fees: there are a lot of optional bells and whistles you can purchase for your annuity, and each of these will carry its own fee. Ask for an explanation of the riders, why you might need them, and the fee associated with each.

4.       Investments: an annuity is similar to a regular old brokerage account, in the sense that it can hold a wide variety of investments like cash, money market funds, mutual funds, exchange-traded funds, and so forth. Here are three common types of annuities based on the investments you can hold:

    a.       Fixed: the insurance company pays you interest on the money in your annuity. Your interest rate is sometimes guaranteed or can change along the way. You’ll get a guaranteed minimum level of income from this kind of contract but you’re not going to keep up with inflation in our current environment if someone is just paying you interest.

    b.       Variable: you earn “interest” based on the investments you choose to hold in your account. Variable annuities can hold mutual funds, exchange traded funds, and so forth, just like a regular investment account. There is usually no guaranteed return unless you buy a rider to do that, but the funds inside the annuity can grow more over time and get you a higher payout. The company usually guarantees at least the return of the money you put in yourself. If you have a long time to invest (10+ years) and some intestinal fortitude, you can handle it!

    c.       Indexed: you earn “interest” based on a market index, like the S&P 500. You’re not participating directly in the stock market but you can earn a higher return than with plain vanilla interest. There is a guaranteed minimum return (or “floor”) with these annuities, BUT there is also a maximum return (or “cap”) which limits on how much value your investments can gain. These annuities are good for people who want to participate at some level in stock market gains but are terrified of a downside due to pandemic, zombie apocalypse, etc. But you pay for that privilege with the cap on your returns.

So when might an annuity be a good choice? In general, I would counsel that an annuity is not an optimal first place to save for retirement. So when IS it a good choice?   

1.       You need tax-deferral on the money you’re saving. An annuity will keep the gains in your account outside of your taxable income, reducing your tax burden and allowing more of your money to grow. Just note that an annuity works best when you’ll be in a lower tax bracket after you retire. Remember that you’ll be paying regular income tax on the gains in an annuity, rather than capital gains tax. For most people, capital gains tax will be lower.

2.       If you have already maxed your 401(k) contributions and still want to save more money on a tax-deferred basis, an annuity might work for you. If you’re able to contribute to an IRA or Roth IRA those are good choices, but some people earn too much to contribute to those vehicles and/or would still like to save more. Annuities don’t have contribution limits, so you can sock away as much as you like.

3.       You don’t have access to a 401(k) plan and want to save more than you can in an IRA or Roth IRA.

4.       You want to guarantee a certain income after you stop or cut down on work. Some people purchase an annuity to cover just their basic expenses, so they can feel more secure when they aren’t earning as much.

5.       You are pretty sure you won’t need the money before you turn 59½. Don’t pay that 10% IRS penalty. You have to pay the government, but you don't have to tip them.

6.       You need long-term care coverage and can’t afford it or you have a health condition which makes you uninsurable. Some annuities now have riders to give you a multiple of your payment if you need long-term care. It’s easier to medically qualify for these riders than for traditional long-term care policies.

7.       You have a health condition which makes life insurance unaffordable or impossible to get. Don’t get me wrong; an annuity is NOT life insurance but it can be another option if you can’t do life insurance. Just realize that taxation for the beneficiary is different and less advantageous with an annuity than with life insurance. But hey, if you can’t get the life insurance this not a bad option.  

OK, that was a lot and this is only a thumbnail sketch of annuities and how they work. It should be fairly obvious by now that annuities are complicated, so don’t be afraid to work with a financial life planner if you’re interested. If you want more in-depth information, here are a couple of online annuity resources:


Shop smart and stay well, my friends.

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Penny Farthing

I, Penny Farthing (non-wizarding name Kerry Read ), actually have a day job in the world of finance. This blog came into being because of my deep and abiding love for geeks and Personal Finance.