An annuity is a financial product that can help you manage your income in your retirement years. It’s essentially a contract between an individual and an insurance company. At the initial stage, you accumulate funds with the insurer, which subsequently pays you a lump sum or a stream of regular payments. To get an understanding of what are annuities, have a look at this simple infographic:
What Are Annuities?
Source – Napkin Finance
You’ll see that the infographic reproduced above illustrates that:
- Money is put into an account.
- The money grows over a period.
- Subsequently, the money is paid out to provide you with immediate income or a series of payments.
The lower part of the infographic explains an important difference between life insurance and annuities. A life insurance policy typically involves a payout to a beneficiary while an annuity usually results in payments to you.
What are annuities most commonly used for? A significant number of people buy them so that they can receive payouts during retirement.
How Can Annuities Help You Save for Your Retirement?
Many small business owners don’t set aside enough money for retirement. In fact, a recent survey found that one-third don’t have a retirement savings plan. Another 36% say that they will look for a job when they retire from their business.
Retirement planning with IRAs vs Annuities
However, this is a shortsighted approach. Retirement planning is essential for small business owners. You could use an IRA plan, which can provide you with tax advantages as well as retirement savings. You can choose between a traditional IRA or a Roth IRA. It’s even possible to invest your IRA in the stock market if you’re willing to bear some risk in exchange for the possibility of higher returns.
But IRAs have an annual contribution limit. You can’t invest more than $6,000 in an IRA annually. If you’re over 50, the limit is $7,000. What if you want to save a bigger sum than this every year? You could consider what are annuities and how they can help you to put money aside for the future.
Benefits of Annuities vs IRAs
One of the key benefits that annuities can provide is an income stream you can’t outlive.
In certain types of annuities, the insurer promises to continue paying you for as long as you live. It can be comforting to know that you’ll continue receiving a regular stream of income for an indefinite period.
When you are trying to understand what are annuities, you should know that they offer another key advantage. They are an extremely flexible financial product. Here are some of the different options that are available when you buy one:
- You can choose to receive payments for a fixed period or the rest of your life. You could also ask the insurer to pay for as long as your spouse is alive.
- What if you pay the insurer and die before you start receiving payments? The annuity could pay the individual who you have named as your beneficiary.
- There are two ways in which you can buy an annuity. The first is by making a lumpsum payment to the insurer. There is also an option to make regular payments, say, once a month for a specific period.
How much should you invest in annuities?
Want to know how much you need to invest to get a certain payout after you retire? Or how much you’ll receive if you save a specific lump sum?
Well, the answer to these questions depends on various factors. How long do you want the income to last? How old are you now? Are you male or female? This information is important as it allows the insurance company to calculate the sum that will be payable to you.
You can use this calculator developed by Fidelity, one of the leading providers of annuities, to get an idea about the payouts through a fixed income annuity.
Don’t forget that there are several kinds of annuities. In the next section, we’ll examine the different types and understand some of their features.
Types of Annuities and Features
Your understanding of what are annuities will be incomplete unless you learn the meaning of fixed annuities, variable annuities, and indexed annuities.
Here are some features of each of these:
What are annuities? – Some features of Fixed, Variable, and Indexed Annuities
|Type of annuity||Fixed||Variable||Indexed|
|Returns||You are guaranteed a minimum rate of return.||You have the freedom to allocate your investment. Your returns will be determined by how the investment performs. ||Your returns are linked to the performance of a specific index like the S&P 500. |
|Level of risk||Your money is relatively safe. However, you could be paying a price for this safety in terms of lower returns. ||Your level of risk is directly linked to your choice of investments. ||This option also carries a degree of risk. If the underlying index performs well, you could benefit. |
|How your money is invested||You aren’t allowed to allocate your investment. The insurance company decides. ||You can choose between different options that could include mutual funds, bond funds, and money market accounts. ||Your money is invested in a manner that tracks a specific index.|
|Who it’s for||The conservative investor. You would rather earn a lower return than risk your principal. ||This option could be risky. If you choose the wrong investments, you could lose some of your money. On the other hand, you could earn high returns, as well. ||Indexed annuities can provide a middle path between fixed and variable annuities. |
Benefits and Risks of Annuities
When you are trying to figure out what are annuities, you may conclude that they are the perfect way to save for your retirement. After all, which product can provide guaranteed life-long returns and the promise of a regular payout in your retirement years?
However, this investment option also carries some downsides. Before you buy an annuity, it’s a good idea to consider the pros and cons:
Pros of annuities
- A source of income for as long as you live – this is one of the greatest attractions of an annuity. Although there are variations that provide a payout for a limited period, you could opt for an annuity that promises to pay you as long as you live.
- Tax advantage – you don’t pay any tax until you start receiving funds.
- You can choose your level of risk – there’s an option to select low-risk, low-return products as well as higher-risk products that carry the potential to provide greater returns.
- An excellent choice if you have reached your IRA contribution limit – annuities aren’t subject to any investment limit. You can buy as large an annuity as you like.
Cons of annuities
- It can be a complicated product – the flexibility of this product can be its disadvantage, too. The terms and conditions of different annuity contracts vary widely. It’s critical that you study the paperwork before you commit your funds.
- Costs for withdrawing early – if you need your money sooner than anticipated, you could have to pay a hefty “surrender fee.” You could lose a sum equal to 10% of your initial investment for an early withdrawal
- Early withdrawals could be taxed at ordinary rates – there could be a negative tax implication, as well. Early withdrawals could be taxed at ordinary rates, which are higher than the capital gains tax rate.
- High fees – some annuities carry several types of charges. Taken together, they can add up to a significant sum and eat into your returns.
Remember that buying an annuity is a long-term commitment. As a small business owner, you may be torn between two options: should you deploying your surplus earnings back into your business, or should you save it for your retirement years? If you find yourself in this situation, the good news is you can do both.
At Camino Financial, we provide entrepreneurs like you with small business loans that can help to provide the funds you need for purchasing capital equipment as well as your other company-related needs.
These are the main features of the loans we provide:
- Small business loans for amounts up to $400,000.
- Fixed monthly installments.
- Loan payback periods ranging from 24 to 60 months.
- Origination fee of 5%. There are no other fees.
- No early payment penalty.
Would you like to know if you are eligible? Our motto is “No business left behind.” So, our team will do its best to match you with the best financing option. You can find out instantly if you prequalify for a loan by providing us with some basic information about your business and yourself.
Tips to Make the Most out of Your Annuities
Now that you know what are annuities, you may be considering buying one. Before you make a final decision, here are some points you may want to consider:
- Annuities are complicated products, and a wide range of options are available. Before you sign on the dotted line, ensure you know what you are buying.
- Beware of high fees. Annuities can carry an annual expense, administrative fees, and in certain products, underlying mutual fund expenses.
- Speak to a trusted financial advisor. Insurance agents and stockbrokers make a lot of money off annuities. Find out if the product you’re buying is really what you need. Or is it only providing a commission to the person who is selling it to you?
- Fixed, variable, or indexed? Make your choice carefully. Don’t sacrifice the safety of your funds for the sake of high returns that may never materialize.
- Finally, don’t buy an annuity with money that you may need in the near term. Making an early withdrawal can be prohibitively expensive.
The Bottom Line
Buying an annuity can be an excellent way to provide an additional income stream for your retirement. However, for most young people, purchasing this product makes sense only if they have utilized their entire limit for their IRAs.
If you decide to invest in an annuity, make your choice carefully. There are a lot of options, and it’s easy to make a financial misstep that could be hard to reverse.
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