Should you buy an annuity for your retirement?

A source of guaranteed income. Annuity contracts offer the ability to annuitize the contract into a stream of guaranteed lifetime income. This can augment other retirement savings vehicles that can fluctuate in value such as IRAs and taxable investment accounts holding stocks, ETFs and mutual funds. 

With so many employers moving away from defined-benefit pension plans offering a contract with a guaranteed monthly income can act as a pension substitute of sorts. 

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Different options. There are several types of annuities that offer different income options for contract holders. With an immediate annuity once the premium is paid, the contract can be annuitized almost immediately. With a deferred annuity, the contract holder can annuitize at a later date. This allows a number of planning options for them. 

A variable annuity offers the ability to invest the money in the contract in mutual fund-like subaccounts generally offering stock and bond investment options. Any growth adds to the value of the contract and the value that can be annuitized later on. 

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A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity that can be purchased inside of a 401(k) or equivalent retirement plan, or inside of an IRA. A QLAC allows the buyer to defer up to $200,000, an increased level under Secure 2.0, into an annuity whose commencement of benefits can be deferred out as long as age 85. The amount in the QLAC is exempt from requirement minimum distributions until the contract is annuitized. 

The ability to customize. Many annuity contracts can be customized, often through the use of contract riders. As an example, some annuity contracts offer a guaranteed minimum income rider that provides a minimum level of income regardless of how the investments in the annuity subaccounts perform. Some annuities may also offer an inflation hedge. 

Tax-deferred growth. Money contributed to an annuity contract grows tax-deferred inside of the contract until it is withdrawn via a lump-sum or annuitized over time. This can offer a means for those who have maxed out other retirement plans another means to accumulate funds for retirement and enjoy the benefits of tax-deferred growth. 

Cons 

Commissions. Some annuity contracts have high commissions that are paid to the insurance agent or registered representative who sells you the annuity contract. In many cases, the commission is paid in a fashion that reduces the value of the annuity contract and the amount may not be disclosed to you. 

Additionally, annuities offer some of the highest commissions available to financial advisers and representatives who sell. In some cases this can lead to an adviser steering a client into an annuity product that might not be totally right for them. 

Fees. Many annuities assess high annual fees. For example, the expense ratios on variable annuity subaccounts are often far higher than the expense ratios on similar mutual funds held outside of an annuity. In recent years there has been an increase in lower cost annuities. It is important for anyone considering an annuity to fully understand the underlying expenses that will be charged as they can significantly reduce the value of the contract over time. 

Surrender charges. Some annuity contracts carry surrender charges. These are fees that would be assessed against the contract if it was surrendered prior to a certain date. Surrender periods can vary, the longest I’ve ever seen was 15 years. The surrender charge is a percentage of the value of the contract that declines over time until the end of the surrender period. 

For example, if the surrender charge is 8% at a point in time and the value of the contract was $200,000, it would cost $16,000 to surrender the contract. This includes an exchange for another contract that might be a better fit for you. Surrender charges can serve to trap you in a contract that may not be a good fit for you anymore. 

Not all annuities have surrender charges, the number of contracts without them seems to be increasing in recent years. 

Tax penalties. If a withdrawal from a nonqualified annuity (an annuity held outside of an IRA or other type of retirement plan) is made before age 59 ½, then the taxable portion of the amount withdrawn would be subject to 10% early withdrawal penalty in addition to the taxes that might be due. 

Qualified annuities held inside of an IRA or other tax-advantaged retirement plan would be subject to a penalty only if money from the annuity was withdrawn from the retirement account and that withdrawal triggers a tax penalty. 

Deciding if an annuity is the right choice for you 

For many people planning for retirement an annuity can be a good choice as part of their overall retirement portfolio. The income benefits and other features of many contracts can augment their other investments and help to provide a steady stream of retirement income. 

In selecting an annuity be sure to understand the features of the contract that you are considering to determine whether this contract is right for you. Also be sure to fully understand all fees and expenses and if there are surrender charges. Verify that the insurance company is financially sound as they are the ones who stand behind the contract.