With proper planning and a long-term strategy, you can build the financial power to enjoy the retirement you want.
One way to plan for retirement is by using investment tools meant to ensure a steady income, such as a fixed index annuity. There are many perks to fixed index annuities, but it's critical to understand how they work to determine if it's the best option for you.
What are annuities?
To fund your annuity, you'll pay either a one-time lump sum or a series of premium payments to your insurer. In return, you'll receive income payments once you're in retirement. The amount and frequency of those payments as well as how you pay your premium all depend on the type of annuity you choose.
When might someone buy an annuity?
An annuity can act as another tool to bolster your monthly retirement income. Working alongside your
Annuities may be a good option for your needs in a few other circumstances, as well. Income from an annuity may help if you want to delay taking your Social Security benefits for a few years. Or, you may have maxed out your 401(k) contribution but still want to save for retirement, making an annuity another possible retirement tool.
Key factors when choosing between annuities
There are a few basic
First, consider when you may need the income an annuity provides:
- Immediate annuity. This may be the best option if you need the money right away. With an
immediate annuity, your insurer gets a one-time lump sum, and you can begin taking income payments over the period you set about a month later.
- Deferred annuity. If you don't plan on taking income from an annuity for years, consider a
deferred annuity.In this case, you purchase the annuity with a single payment or a set number of premiums, which grow tax-deferred until you begin withdrawing income.
You also may weigh options by factoring in your preference for risk level:
- Fixed annuity. A
fixed annuityis often considered the least risky option because the annuity earns money at a fixed interest rate set each year. The rate is usually around 1%-2%. However, this rate may not keep up with inflation.
- Variable annuity. A
variable annuityis usually considered the option with the highest earning potential—but it comes with risks. You can invest your premium in sub-accounts similar to 401(k)s; your total available income may depend on the market performance of your selected investments, meaning that you could lose money.
- Fixed index annuity. This middle option may offer more growth than a fixed annuity and less risk than a variable annuity. The interest is tied to an index, such as the S&P 500, and may fluctuate based on how the index performs (subject to an upper cap).
As you choose an annuity, you can mix and match your needs. As a hypothetical example, you may opt for an immediate fixed annuity or a deferred variable annuity.
What is a fixed index annuity?
A fixed index annuity typically sits in the middle of the potential risk spectrum between a fixed and a variable annuity. As a result, it provides a tax-deferred savings option that may offer more protection than a variable annuity while still allowing for some growth opportunities.
It provides the option to tie your interest to an index, such as the S&P 500. Your interest amount is based on how the index performs up to a predetermined cap. If, as a hypothetical example, the market is doing well and the index is up, you could get a higher interest rate compared with a set fixed annuity, allowing you to add more value to your annuity. This creates the potential for more growth if the index performs well—and, at the same time, it limits your exposure if it does poorly.
Although your premium is tied to the index's performance, funds are not directly invested in it. This means that even if the market goes down and the index your annuity is tied to doesn't perform well, the annuity doesn't lose value.
How does a fixed index annuity work?
You have the flexibility to decide how you want to fund your annuity. For instance, if you prefer to do it via a one-time lump sum payment, you can roll over a 401(k) or IRA or use the proceeds from the sale of an asset. Alternatively, you can choose to pay a series of premiums.
Because annuities work as both savings vehicles and a source of retirement income, they work in two phases. The first is the accumulation phase, where you save assets for retirement and build the amount of money in the contract. During this phase, the money in your annuity can earn a higher interest rate based on the performance of the index it's tied to. Since your money isn't invested in the market, you don't assume the risk of losing it—your annuity's value may benefit from strong market performance over time, but it won't lose value if the market goes down.
An annuity moves from the accumulation phase to the distribution phase in a process called
If you choose a deferred annuity, then the time between when you start funding it and when you can begin to withdraw is preset. However, you have the flexibility to decide how you'd like the money from your annuity to be disbursed:
- As a one-time lump sum payment
- As monthly income over a period of time, such as for the rest of your life
- By withdrawing specific amounts
Depending on the annuity, you also may choose a joint income, which covers you and a spouse for life.
Sitting down and working with a financial advisor can help you determine how much to contribute to an annuity and narrow down the best options for distribution.
How is the interest rate credited to the indexed annuity?
Once you begin funding your annuity, the interest you earn on your money is tied to an index. The rate caps at a specific limit, but your interest rate will never go below zero if the market goes down.
As a hypothetical example, say you fund your annuity for $100,000. It's tied to the index's performance on your premium allocation anniversary, and your interest rate is capped at 4%.
- If the index return is positive and above the cap: You'll get the capped interest rate credited to your account. If the index earns 8%, you will get 4% (the cap).
- If the index return is positive but less than the cap: You'll get an interest rate credited to your account equal to the index return. If the index earns 2.5%, you would get credited 2.5%.
- If the index return is negative or zero: You won't see any loss to your value, but you won't receive any gain either. If the index is down 10%, your return value will remain flat.
Confirm the time period used to measure index returns with your financial advisor. It may run along the calendar year or during specific predetermined points in time.
What are the pros and cons of fixed index annuities?
Review all your options to understand the pros and cons of each. Doing the research helps you determine the investment tools and strategies that will work best for you.
As with any investment vehicle, fixed interest annuities carry both advantages and disadvantages.
Benefits of fixed index annuities
- Guaranteed income in retirement. An annuity provides guaranteed income in retirement. Many also offer joint income, which can cover a spouse.
- Less risk and more reward. A hybrid between fixed and variable, a fixed index annuity offers added growth potential without as much risk.
- Protection. With this type of annuity, you won't lose value due to market fluctuations. Periods with higher interest returns may offer a way to help hedge against inflation.
- Tax-deferred. You don't pay taxes on your annuity until you begin withdrawing, leaving more money in your annuity for potential growth over time.
- Beneficiaries. You may list a beneficiary on your annuity, so you can pass on the death benefit to a loved one if you were to pass unexpectedly.
Disadvantages of fixed index annuities
- Capped gains. If the market performs well over a long stretch, you may not be able to take advantage as much, because your interest gains are limited.
- Early withdrawal fees. If you need to withdraw funds earlier than you expected, you may face fees as high as 10%.
- Fees. You may see higher administration and maintenance fees on annuities than you would compared with some other retirement tools, such as a mutual fund.
The bottom line
For some, adding an annuity may be an excellent tool for your long-term retirement strategy. However, annuities may not be the best fit for everyone. That's why understanding the ins and outs of each type of annuity makes such a difference.
A financial advisor also can help you consider both your current financial situation and your future retirement goals, working to find the best possible fit for your needs.
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