Setting up an annuity for retirement can be a great way to help you ensure that you have the money you need to pay your living expenses in your life after work. Retirement annuities can be used to create a steady, guaranteed income stream that can power your future.
Sounds great, right? Still, many people don’t have a ton of information about annuities, how they work, what additional benefits they offer, or what potential risks are associated with them. If you’re considering retirement options, understanding the basics of how annuities work should be the first part of your strategy.
How Do Annuities Work?
An annuity is a contract between an individual and an insurer, which stipulates that in exchange for one or more up-front payments, the insurer will provide the individual a regular stream of income, either for a fixed period of years or for the rest of their life.
Annuities operate in two distinct phases: the contribution phase and the annuitization phase. During the contribution phase, the annuitant (the owner of the annuity) makes payments to the annuity to help grow its value. The annuitization phase is the period of time when the annuity starts paying out money.
The initial contribution grows on a tax-deferred basis. The annuitant pays taxes on earnings as they are withdrawn from the account. There are several different types of annuities, so it’s important to understand the specific terms of an annuity contract before you buy.
The two major categories of annuities are immediate annuities and deferred annuities. These are typically defined by whether there’s a delay between the initial contribution and the start of the annuitization phase.
Immediate Annuities
An immediate annuity is an annuity product that enters the annuitization phase almost immediately after the initial contribution is made. This type of product is often used by those who suddenly come into a large sum of money (like lottery winnings or major inheritance) and want to make that money stretch out to last for a long period of time.
Deferred Annuities
Some annuities are designed to grow for a number of years before they begin to pay out their guaranteed income stream. These annuities with long contribution phases are referred to as deferred annuities. On a deferred annuity, you can either make a single lump-sum contribution or make repeated contributions at any time before the annuitization phase to help build up the principal over time.
Fixed Vs. Variable Annuities
In addition to being immediate or deferred, annuities can also be fixed or variable-rate. The major distinction here is that fixed-rate annuities grow at a set interest rate over time. Meanwhile, variable-rate annuities allow the money in them to be used in an investment portfolio that has a chance for higher growth (but with a commensurate increase in risk as well if the investment doesn’t perform to expectation).
For example, say you have $1,000 to put into a deferred annuity that you plan to collect on in 20 years. If you put it into a fixed annuity at a growth rate of 2%/year, then at the end of 20 years, you’d have about $1,485.95.
However, if you put that into a variable annuity with interest that can go up or down by 10%/year (just as a hypothetical: actual growth rates could vary outside of this range depending on the investment) off of a 2% average. This could mean up to 12% growth or as low as an 8% loss in any given year. After 20 years, that investment may fall anywhere between $9,646.29 and $188.69.
Considering your risk tolerance is important, even when it comes to annuities.
Annuity Benefits for Retirement
So, what are the benefits of investing in an annuity? What’s the compelling reason to purchase an annuity if you’ve already made contributions to your 401(k) or an IRA?
Here are a few of the benefits of setting up annuities for your retirement planning:
Compound Interest Growth
As an annuity grows over time, its power to grow increases. That’s because annuities earn compound interest: the interest earned is added to the interest-earning amount, allowing the account to accumulate more value each year.
The results can be dramatic for your retirement income.
For example, $10,000 earning 5% simple interest for 10 years will earn a total of $5,000.
$10,000 x .05 x 10 years = $5,000
If that same $10,000 earns compound interest at the same 5% rate for 10 years, earnings will grow to $6,288.95.
$10,000 x (1.05)10 – 10,000 = $6,288.95
Here, compound growth results in an additional $1,288.95 of earnings on the initial investment.
Tax Deferral
Another major benefit of an annuity, especially a deferred annuity, is that it allows the money invested to grow on a tax-deferred basis. Tax deferral means that you can postpone tax payments on the money while it’s growing. Instead, taxes are only paid on earnings as the money is withdrawn from the account.
Tax deferral adds earning power to compound interest because it leaves more in the account each year, allowing annuitants to accumulate more interest. This contrasts with certificates of deposit (CDs), which are subject to annual taxes on earnings.
The amount of extra growth made possible by tax deferral combined with compound interest may vary depending on your tax bracket for each tax year. For argument’s sake, let’s say you invest a $10,000 principal with 5% interest like in the previous example. After ten years with compound interest and no taxes, it would earn $6,288.95.
However, if the earnings on that money were to be taxed each year, the growth would slow significantly. For simplicity’s sake, let’s assume that the money earned is taxed at 24% (note that this may change depending on your overall taxable income for the year).
Without being taxed, the earnings for the first year would be $10,000 x 0.05 = $500 of income. With taxes, the calculation would look more like $10,000 x 0.05 x 0.76 = $380. This shrinks the first year’s earnings, which has a compounded effect on subsequent years' earnings as well. So, after ten years, the money would grow by roughly $4,520.23 instead of $6,288.95—a difference of $1,768.72. The longer the money is given to grow, the more pronounced the difference will become between the taxed and the tax-deferred earnings.
Flexibility of Withdrawals (Deferred Annuities)
If you purchase a deferred annuity, you can make withdrawals from it before (and in addition to) the scheduled income payments. However, the amounts you can withdraw and the effects of early withdrawals can vary depending on annuity terms, so be sure to read the annuity contract carefully and discuss it with a financial advisor prior to signing or making an early withdrawal.
A potential consequence of taking an early withdrawal would be reducing the amount of growth your annuity sees before its annuitization period, though other penalties may apply depending on the annuity contract terms.
Planning Around Medicaid Eligibility
Another important way that many Americans use annuities to enhance their retirement is by using them to qualify for Medicaid coverage. Many of us will need paid long-term care services as we age, and the high cost of care can become a large financial burden. Medicaid provides long-term care coverage, but individuals must meet strict income and asset limits to be eligible for Medicaid coverage.
Medicaid-compliant single-premium immediate annuities can help many individuals qualify for Medicaid by transforming high-value assets into a fixed income stream. This can help families access the assistance they need in caring for their aging loved ones and prevent them from going deeper into debt in the process.
Potential Risks of Annuities
What are some of the potential risks of purchasing an annuity? Here, the type of annuity you purchase can have a significant impact on the type of risks you’ll face:
Liquidity Issues (Immediate Annuities)
If you purchase an immediate annuity, you won’t be able to access your money ahead of the income schedule stipulated in the annuity contract. For this reason, it’s critical to ensure that the stream of income will be sufficient to meet your needs before committing money to an immediate annuity.
Consult with a financial planner before buying an immediate annuity that converts a high-value asset or large lump sum payment into a long-term income stream.
Risk of Loss (Deferred and Variable Annuities)
Deferred annuities carry a higher degree of loss risk than immediate annuities. This is because more time passes before the income stream begins, increasing the likelihood that the annuitant will die before receiving the intended return.
Often, however, it’s possible to name a beneficiary who would receive at least the amount paid into the annuity if the annuitant dies prior to receiving that amount in income. This is a critical estate planning issue that you may need to consult your financial planner or accountant on before signing up for a deferred annuity with a payoff date in the far future.
On the other hand, variable annuities can present a risk similar to investing in the stock market: the value of the annuity fund might shrink. This is because, although the money may grow on a tax-deferred basis, it is still being invested in products that may or may not see positive growth as a means of increasing the annuity's value. While this can result in higher growth, there’s always a risk that, in any given year, the total value of the annuity fund may shrink.
Find an Annuity for Retirement Today
ELCO Mutual Life and Annuity have been providing financial security and personalized customer service for more than 70 years. Learn more about our annuity options on our website, or browse our blog for more annuity and life insurance-related topics.
This blog is not intended to serve as financial advice—it is meant to get you thinking about your retirement planning options and ways to fund your goals after you retire. Please consult with a certified financial planner or your financial advisor before making significant investments in annuities or any other financial product.
