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What Is an Annuity and How Does It Work?

Let’s play a little game. All you have to do is answer this question. Here we go: Would you rather take $500,000 in cold, hard cash the day you retire or have $2,700 deposited into your account every month for the rest of your life?

It’s not a trick question. A survey asked Americans who haven’t retired yet that same question, and a whopping 62% of them said they would take the $2,700 a month.1

Why is that? Well, with uncertainty swirling around Social (In)Security and pension plans starting to dry up, many people are looking for monthly security when it comes to their finances—especially retirement planning.

Only 29% of Americans are very confident that they will have enough money to live comfortably throughout their retirement years.2 That might explain why more than half of workers would be very interested in  an annuity if it was offered through their employer’s retirement plan.3

The ultimate goal of an annuity is to give you a steady stream of income throughout your retirement, which sounds great at first. But are annuities really the best way to secure a stress-free retirement?

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Let’s take a closer look at what annuities are, how they work and whether or not they should be part of your retirement savings strategy. First of all, what is an annuity exactly?

What Is an Annuity?

Often marketed as a financial product, an annuity is basically a contract between you and an insurance company designed to provide an income that is guaranteed for the rest of your life. You make a payment (or payments) to an insurance company and, in return, they promise to grow that money and send you payments during retirement.

Annuities are very complex and they come in several different shapes and sizes, but when you boil it down, they’re an insurance product. You’re paying the insurance company to take on the risk of you outliving your retirement savings.

From there, the various types can get complicated. If you’re not careful it will make your head spin, so let’s break it down.

What Are the Different Types of Annuities?

There’s a lot to cover when it comes to annuities, so we’re going to take things one step at a time. The first thing you need to know is that there are two main types of annuities you can choose from: fixed and variable.

Fixed Annuities

Fixed annuities are basically a savings account with an insurance company. They’re similar to a certificate of deposit (CD) you can find at most banks and they offer guaranteed rates of interest, around 5%.

We're just going to tell you right now that fixed annuities aren’t worth your time. If you’re saving up for retirement, the rate of return that fixed annuities offer just won’t cut it. You can do much better than that with good growth stock mutual funds. Stay away!

Variable Annuities

Variable annuities, on the other hand, are a bit different. They’re basically mutual funds stuffed inside an annuity. So unlike the fixed annuities, your payments in retirement will depend on how well the mutual funds you choose perform. That’s why they’re variable.

With a variable annuity, you put in money that’s already been taxed and then the account grows tax deferred. That means you’ll have to pay income taxes on whatever growth the annuity makes when you start taking money out in retirement. We’ll talk more about variable annuities in a minute.

How Do Annuities Work?

Putting an annuity together is a lot like ordering a burrito at Chipotle, just not as tasty. You can create an annuity based on your preferences and your own personal situation, minus the chips and guac. Here are the different ways you can put an annuity together. 

Single vs. Multiple Premiums: How do you want to pay for the annuity?

If you have a large pile of money—maybe through years of saving or an inheritance—you can pay for an annuity in one big payment. Or you can pay for the annuity with a series of payments over many years.

Immediate vs. Deferred: When do you want to receive payments?

You can choose whether or not your annuity pays you right away (immediate annuity) or at some point in the future (deferred annuity). Keep in mind that if you take out any money from your deferred annuity before age 59 1/2, you’ll get hit with a 10% early withdrawal fee on top of the income taxes you’ll owe!

Lifetime vs. Fixed Period: How long will your annuity payments last for?

In addition to choosing when you’ll start receiving annuity payments, you’ll also need to decide how long those payments will last. One of your options is a lifetime annuity that will pay you a certain amount for the rest of your life. Or you could go with a fixed period annuity that will send you payments for a set amount of time—anywhere from 5 to 25 years.

What Are the Benefits to Having an Annuity?

There are some benefits to having a variable annuity (though they don't outweigh the cons). For starters, you can leave a beneficiary on the annuity so that the payments you were getting can go to a loved one when you die.

Some variable annuities even offer a guarantee on your principal investment. So basically, if you put $200,000 into an annuity and the value of the investment drops below that, you’ll still get your $200,000 when you take your money out.

And unlike a 401(k) or an IRA, annuities don’t have yearly contribution limits, so you can put as much money into an annuity as you’d like.

A lot of this sounds pretty appealing at first, but we want you to pump the brakes for a minute. Screech! There’s a reason why many people who look into an annuity stop dead in their tracks and run the other way before signing on the dotted line.

What Are the Drawbacks to Having an Annuity?

Annuities are bogged down by a lot of fees that cut into the return on your investment and keep your money tied up. You’ll find that if you want to get your hands on the money you’ve put into an annuity, it’s going to cost you. This is why we don't recommend annuities.

Remember, annuities are basically an insurance product where you are transferring the risk of outliving the money you’ve saved for retirement over to an insurance company. And that comes at a steep price.

If you want to know, here are just some of the fees and charges you’ll see attached to an annuity:

  • Surrender charges: These can really trip you up if you’re not paying attention. Most insurance companies set a limit on how much you can take out for the first several years after you buy an annuity, called the “surrender charge period.” You’ll be charged a fee on any money taken out beyond that limit, and those charges can cost you a pretty penny. And that’s on top of the 10% tax penalty if you take out your money before age 59 1/2! 
  • Commissions: One of the reasons why insurance salesmen love pitching annuities to folks is that they get big commissions from selling annuities—sometimes up to 10%! Sometimes those commissions are charged separately, other times those surrender charges we just talked about cover the commission. When you’re listening to a sales pitch for an annuity, make sure you ask how much of a cut they’re getting.   
  • Insurance charges: These might show up as a “mortality and expense risk charge.” Basically, these charges cover the risk the insurance company takes on when they give you an annuity, and they’re usually 1.25% of your account balance per year.3
  • Investment management fees: These are just what they sound like. It costs money to manage mutual funds, and these fees cover those costs.
  • Rider charges: Some annuities offer extra features that you can add to your annuity—things like long-term care insurance and future income guarantees. These extra features are called riders, and they’re not free. There’s a fee for those riders too.

Are Annuities Ever a Good Idea?

We're going to come right out and say it: For most people, an annuity just doesn’t make sense. While a guaranteed income is great, you have a much greater earning potential with mutual funds and the 401(k) you get at work.

Still, a variable annuity might make sense for some people who are further along in their investing. The only time you should even think about adding a variable annuity to your investment strategy is when you’ve already maxed out all of your other tax-favored retirement plans, that means your 401(k) and Roth IRA, and you’ve paid off your house completely.

Even then, there are a few other investment options we would recommend looking into before annuities—like health savings accounts, taxable investment accounts or even real estate. You can sit down with an investing professional who can help you sort through the good, the bad and the (sometimes) ugly of each option. Remember, never invest in anything you don’t understand.

Annuities are not a replacement for traditional tax-advantaged retirement vehicles. Never put a retirement account that already has tax advantages into an annuity. You don’t get any extra tax benefits from putting a 401(k) or IRA into an annuity—only more fees. Pass!

Talk With an Investing Professional

At the end of the day, it’s up to you to secure your financial future, not an insurance company. If you want to have the retirement of your dreams, you need to use an investment strategy that works and stick to it. In fact, we found that the number one contributing factor to millionaires’ high net worth is investing in workplace retirement plans.4

If you’re ready to get started, check out SmartVestor. With this service, you’ll be connected to investment professionals in your area who know their stuff—and they’re eager to work with you!

Find a SmartVestor Pro today!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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