Of all of the investment products out there, annuities may be the most misunderstood. Some people love them, others hate them. Hardly anyone completely understands them.
Annuities are sold by insurance companies, and they are a contract between the investor and the carrier. The contract says that the investor will give the insurance company money, either as a lump sum or over time, and in return the insurance company will guarantee the investor a lifetime stream of income.
They're Not All Bad
Annuities sometimes get a bad rap for having high fees and paying big commissions to the financial advisors who sell them. While it's true that your advisor may collect a large commission up front for selling you an annuity, the costs over time may be comparable to other investments. When you factor in guarantees on interest rates and income, they can be a very good choice in some circumstances.
But They're Not for Everybody
An annuity is designed to be a long term investment. There are significant penalties for withdrawing money in the first several years. Consider an annuity only if you have a sum of money you can lock up for at least ten years, or until retirement.
Interest Rates and Tax Brackets Matter
Many annuities have a minimum interest rate or rate of return they will pay, regardless of market performance. In times of market volatility and low interest rates, both of which we've seen recently, these minimums can make them a very attractive investment. Keep in mind, however, that annuities are a long term investment and interest rates and market returns will change over time.
Annuities can also be an attractive investment if you are in a high tax bracket now, and anticipate that your bracket will be much lower in retirement. As with interest rates, you'll need to make some assumptions about what tax rates are likely to do in the future.
You Probably Don't Want One in Your IRA
Some people buy annuities because they offer tax-deferred growth. This means that the earnings compound, and you don't pay taxes on them until you start withdrawing the money. This is the same advantage that a 401k or IRA offers, so most people shouldn't pay the additional fees for an annuity since they're already getting the benefit of tax-deferred growth. The exception is people who have maxed out their IRA or 401k contributions and still want to invest for retirement.
Charities Love Them
An annuity can make a very effective vehicle for philanthropy. Using an annuity, you can make a charitable donation that will reduce your taxes or those of your heirs, and receive a lifetime income stream as well.
Annuities aren't for everyone, but in the right circumstances, they can be a good addition to your investment portfolio. Be sure you understand all the fees, charges and riders so that you and your investment professional can make the right choice.