Pros and Cons of Annuities

If you haven't investigated annuities yet, you may wonder what they are and what they can do for you. Keep reading to learn how they work and the advantages and disadvantages of annuities.

Image source: Getty Images.

Where to invest $1,000 right now? Our analyst team just revealed what they believe are the 10 best stocks to buy right now. Continue »

What is an annuity?

An annuity converts money into guaranteed income for a specified period. Depending on the type of annuity you choose, you may receive payments for a few years or for the rest of your life.

Annuities are typically sold by licensed life insurance agents who work with or for banks or brokerage firms. There are various types of annuities, each tailored to meet your specific needs and preferences. For example:

• Deferred annuity: A deferred annuity involves making a lump-sum payment or a series of payments that grow over time. Deferred annuities are popular among those planning for retirement.
• Fixed annuity: This type of annuity provides a guaranteed, fixed rate of return for a specific period.
• Immediate annuity: As the name implies, you make a lump-sum payment and begin receiving payments within a year.
• Indexed annuity: An indexed annuity links your earnings to a market index (like the S&P 500). You get the potential for higher returns and some protection against market downturns.
• Variable annuity: You invest in "sub-accounts," similar to mutual funds. Returns fluctuate based on market performance.

Each type of annuity offers its own pros and cons. In general, here are the good and not-so-good features of annuities:

Pros of annuities

• Guaranteed income: One thing that draws people to annuities is the stable and predictable income they provide for a specified period. Annuities are particularly popular among those seeking to secure financial stability in retirement.
• Customization: Some annuities have optional features such as inflation protection or various payout structures.
• Tax benefits: Earnings on the money you invest in an annuity grow tax-deferred until they're withdrawn (much as with a 401(k) or traditional IRA). This can be beneficial for long-term growth.
• Protection: Fixed annuities protect against market fluctuations by providing a guaranteed return. For the conservative investor, a fixed annuity may be the ideal choice.
• Estate planning: It's possible to structure an annuity so that it can be passed to beneficiaries, a benefit that can aid in your estate planning.
• Extra security: If you're concerned that you may outlive your savings, an annuity can help by providing income for life.

Cons of annuities

• High fees: One of the most significant drawbacks of annuities is the number of fees they charge. You may end up paying management fees, mortality charges, policy surrender fees, and other additional costs.
• Complexity: There's no denying that annuities can be a complex financial product. There are numerous options, terms, and conditions, making it challenging to fully understand what you're paying for.
• Inflation risk: It's possible that fixed annuities won't keep pace with inflation. Falling behind inflation erodes your purchasing power over time. One option is to pay more for a policy with inflation protection.
• Tax implications: Like many employer-sponsored retirement plans, withdrawals from an annuity are taxed as ordinary income. You may find that the ordinary income rate for you is higher than the capital gains tax rate associated with other investment vehicles.
• Lack of liquidity: Funds in an annuity may be tied up for decades, depending on when it's purchased. While it's possible to make early withdrawals, doing so typically means incurring a substantial penalty. In an emergency, the ideal situation would be to have other sources of cash.
• Surrender charges: Many annuities charge a surrender fee if you withdraw funds within a specified period (typically during the first five to 10 years). While it's easy to understand why a bank or brokerage wouldn't want you to do that, it does limit access to your money.

Given the pros and cons, it's vital to fully understand an annuity agreement before signing. If you have any questions, your agent can provide clarification.

Dana George has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.