How annuities work & when you might need one

The bottom line:

The right annuity can guarantee income for a lifetime.

Annuities combine savings & insurance into one product.

There are four main types of annuities: immediate, deferred, fixed & variable.

• What is an annuity?
• Why do people buy annuities?
• The four main types of annuities.
• What are the tax advantages of an annuity?
• When should you think about buying an annuity?
• How much money do you need to start an annuity?
• Can you lose your money in an annuity?
• Do annuities count as assets?
• What happens to the money in an annuity when you die?
• Who should not buy an annuity?
• Is an annuity a good investment for an elderly person?
• How do you choose the right type of annuity?

An annuity is an insurance contract that guarantees income in retirement. It can guarantee income for a set period of time (such as 25 years) or for the rest of your life. You put money into it once or make a series of payments. In return, you receive income in retirement. Income is usually monthly but can be paid at other intervals such as yearly.

There are two stages to any annuity contract.

• The first stage is the accumulation stage, or the period where you save and potentially grow your retirement funds while building the cash value of your annuity.
  
• The accumulation phase ends at the onset of the distribution stage. This is when you're ready to begin withdrawing funds to create an income in retirement.

People buy annuities to help ensure they will have enough money in retirement. This financial product is one of the few that provide a lifetime income stream. If you’re thinking to yourself, “Wait a minute. Social Security provides a lifetime income stream in retirement,” you’re right. Social Security is similar to an annuity income stream.

But Social Security and pensions (if you have one) often fall short of providing enough money for retirement. And it can be tough to predict how long your savings will need to last. Will you live to age 75? Or to age 105? It’s scary, but possible, to run out of money in retirement.

When done well, annuities can help provide cash for your later years. They’re somewhat like insuring your home or car for the unexpected. They help ensure that you don’t outlive your savings in retirement. You’ll see annuities used alongside a 401(k) or other retirement planning tools.

Some annuities are relatively low-risk, guaranteeing income in retirement at a steady growth rate—often around 1% to 2%. Other annuities are higher-risk, with funds tied to market performance—and the gains and losses that come with it. All annuities come with costs such as surrender charges, mortality and expense risk charges, and administrative fees. The money contributed to an annuity typically can't be removed without a penalty charge. You’re trading access now for guaranteed payouts later on.

Annuities come in many shapes and sizes. The four basic types are immediate fixed, immediate variable, deferred fixed and deferred variable annuities. The types are primarily based on two factors: when you want to start receiving payments and how you would like your annuity to be invested.

• When you are planning to begin receiving payments – You can either receive your annuity payments immediately after paying the insurer a lump sum (immediate payments) or you can receive monthly payments in the future (deferred payments).

• How your annuity investment may potentially grow – Contributions to an annuity can grow in a couple of different ways – through interest rates (fixed return) and by investing your contributions in the market (variable return).
  

Immediate annuities provide a retirement income stream that starts right away and are designed to provide an immediate lifetime payout. You usually pay your insurer a one-time amount (a lump sum). Then, you begin receiving payouts.

A potential drawback of immediate annuities is that you're trading liquidity for guaranteed income. You generally won't have access to that full lump sum if you need it. There are two main types of immediate annuities: immediate fixed and immediate variable.

Deferred annuities provide a retirement income stream that starts at a later date. You can pay your insurer a one-time amount or make a series of payments over time. Your income payouts will begin at an agreed-upon future date. One of the benefits of a deferred annuity is that earnings grow tax-deferred. The money in your annuity can grow now, with taxes owed later when you withdraw funds. There are two main types of deferred annuities: deferred fixed and deferred variable.

Fixed annuities pay a fixed rate—usually 1% to 2% each year, for an agreed upon period of time. When your contract is over, or at the end of the guarantee period, you may choose to either annuitize your contract, renew your contract, or transfer your invested dollars into another annuity contract or retirement account.

Because fixed annuities offer a guaranteed interest rate, your income is typically not impacted by market volatility so you can anticipate the amount of your monthly payments. Of course, a downside of remaining in a fixed annuity with a guaranteed interest rate would be the inability to benefit from potential upswings in the market. In addition, the guaranteed interest rate may not keep pace with inflation. There are two main types of fixed annuities: immediate fixed and deferred fixed.

A variable annuity is a type of tax-deferred annuity contract that allows you to invest your money into sub-accounts, similarly to a 401(k). Sub-accounts can help an annuity’s growth keep up with, and potentially outpace inflation. Like mutual funds, sub-accounts are dependent upon market risk and performance.

You may also wish to consider adding guaranteed income riders to your variable annuity. Guaranteed income features may allow you to feel more confident about the future so you can focus on your goals in the present knowing you won't outlive your money. A guaranteed lifetime withdrawal benefit, or GLWB, is a rider which helps protects against both longevity risk and market risk. This dual protection may be beneficial if you are 15 years or less from retirement.

A variable annuity can be a great addition to your retirement income plan if you've already maxed out your Roth IRA or 401(k) contributions for the year.

The growth within an annuity is tax-deferred. So taxes on earnings or interest aren’t due until you begin receiving payouts (usually, after you retire). This means the money inside an annuity can grow faster. Beyond that, tax advantages vary by type of annuity. For example, immediate annuities begin paying you right away. So they don’t leave much time for growth—tax-deferred or otherwise. Deferred annuities are the opposite. They leave ample time for growth.

Choosing to buy your annuities with before- or after-tax money can also make a difference at tax time. Before-tax money is money from an IRA rollover or a 401(k). With before-tax money, you’ll pay income taxes on your total withdrawal. After-tax money is from your savings account, an inheritance or a work bonus. With after-tax money, you’ll only pay taxes on growth.

Tax downsides include: Withdrawals from annuities, including partial withdrawals and surrenders, may be taxable. If you take a withdrawal before age 59½, you may have to pay a 10% penalty to the IRS in addition to your normal income tax. Additional surrender charges may also apply. As always, read your prospectus and contract documents for full information.

While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional or attorney.

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You should consider buying an annuity if you’re building a retirement plan. Though planning for retirement often works better the earlier you start, many people don’t consider an annuity until late in life. But there are other common times and life events when it makes sense to consider an annuity.
Here are a few of them:

• You’re nearing (or already at) retirement age and have limited funds in a pension account. Do you have your retirement money sitting in a low-interest savings account? Then an annuity may be worth considering.
  
• You need to shrink your required minimum distributions from retirement accounts. Already retired? At least one type of annuity may help you postpone required minimum distributions until a later age. A qualified longevity annuity contract (QLAC) is designed to help meet IRS requirements.
  
• You want to delay Social Security income. Annuities may provide an income stream that allows you to delay when you begin collecting Social Security.
  
• You’ve maxed out your 401(k). Annuities are a retirement planning product. Consider them as you look for other places to make retirement contributions.

Insurers often require a minimum initial contribution to open an annuity. This may be an amount like $5,000 or $10,000. However, it will vary by insurer and contract.

Also pay attention to maximum contribution limits. As with other tax-deferred products, annuities sometimes have contribution limits set by the IRS. A qualified longevity annuity contract, for example—which requires contributions through an IRA or other qualified funding source—can accept a maximum of $200,000 in 2023, and will be indexed for inflation in future years.

Each type of annuity will have its own requirements, so consult with a financial advisor for details.

Yes, you can lose money in an annuity. First, understand the risk based on the type of annuity you have. Variable annuities may experience loss because of how the product is structured. Variable annuities are tied to market investments, which involve risk. You could lose your interest or earnings and the principal you contributed. Don’t choose a variable annuity as part of your retirement plan if you are averse to this type of risk.

It’s also possible to lose money in annuities if the organization you choose dissolves. Or if it is unable to pay its obligations when you retire. Avoid this problem by choosing an organization with a strong rating. Look at reports from institutions such as AM Best, Fitch, Moody’s, or Standard & Poor’s.

Fees, expenses and penalties can also impact the amount of money in an annuity. Factor them in as you calculate expected returns. Early withdrawals (before age 59½), for example, can result in a 10% penalty paid to the IRS on the amount of the gain withdrawn, in addition to your normal income tax. Early withdrawals often carry surrender charges owed to your financial institution, too. As always, read your prospectus and contract documents to learn what’s true for your contract.

Yes, an annuity is an asset. It is something of value that’s available to meet commitments or debts. However, the time when your annuity will be available to meet commitments or debts varies with the type of annuity you have. This means that an annuity (especially a deferred annuity) might not always qualify as a liquid asset during financial reporting. Usually, the decision to buy an annuity means trading access (liquidity) now for an income stream later on.

Consult with a tax advisor for advice specific to your situation.

Some annuities provide a death benefit. It guarantees your beneficiaries receive at least the amount you contributed, minus any withdrawals or fees. Lifetime income annuities usually provide a death benefit. If this applies to you, don't forget to name a beneficiary.

For other annuities, the insurance company may state in the contract documents that the money is theirs to keep at the time of your death. (This is true of life-only annuities.) Rules vary by organization and annuity type. Talk with a financial advisor and read your contract documents to learn what’s true for you.

If you’re in poor health and have a shortened life expectancy, annuities may not be right for you. Annuities can also be the wrong choice when they don’t align with your overall financial strategy or goals. For example, if you’re saving to start a business when you turn 40 years old, annuities probably don’t make sense. Annuities are a long-term retirement product.

There are also scenarios where annuities generally make less sense. At certain ages, for example, an annuity may not be the right savings vehicle. At an advanced age like 90, the value of a lifetime income source is significantly diminished for most people. At a younger age like 18, it may be a better financial move to focus on maxing out an employer-sponsored 401(k) match. However, your situation may vary from these examples.

Consider enlisting the help of a financial advisor or broker. They can help sort through the diversity of annuity products on the market. You’ll need to consider age, savings, single/joint status, life expectancy, state of residence, retirement finances and risk tolerance to find an appropriate annuity.

Annuities may be a good choice for an older person if they align with that person's financial goals and strategy.

Because Social Security and pensions can fall short, annuities may help provide enough funds in retirement. Use them to complement other sources of income. Before buying, consider impacts to health care, expected nursing home contributions and taxes. Factor in your age, savings, single/joint status, life expectancy, state of residence, retirement financials and risk tolerance when selecting.

People who need retirement income now should start by looking at an immediate annuity. For retirement income later, start with a deferred annuity.

Do you want to play it safe and have a guaranteed stream of retirement income? Or do you want to take a financial risk in exchange for potentially higher rewards or losses? If you have a lower risk tolerance, start by looking at a fixed annuity. If your risk tolerance is higher, start by looking at a variable annuity.

By doing this, you’ll know what type of annuity aligns with your financial strategy and goals. Read the types of annuities section for more help on this.

If you want to include the people who are affected by your decision, now may be a good time.

Comparison shopping can help you see differences in annuity fees and expenses. Enlist the help of a financial advisor if you could benefit from help understanding the options. Pay special attention to annuity fees and expenses.

Make a retirement review part of your year-end financial checkup. Reevaluate if you’re on track for retirement.

Want to learn more about how annuities can help reduce the risk of outliving your savings in retirement by creating a reliable income stream? Contact a Thrivent financial advisor to find out if an annuity is right for you.