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Are Annuities the Right Investment for Your Retirement?

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Here are the basics of annuities that you need to know about.

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Do you want guaranteed income for life? Who doesn't? That's why insurance companies are ramping up their marketing of annuities.
But before you buy in, you should know what you're getting into. Annuities are not that easy to understand and they may not be right for every retirement situation.

Here are some basics to understand, plus some pros and cons.

What are Annuities?

Annuities are financial contracts issued by a life insurance company that offer tax-deferred savings and a choice of payout options – income for life, income for a certain time period or a lump sum – to meet your retirement needs.

Because an annuity contract gets tax-deferred treatment, the IRS may impose an early-withdrawal penalty of 10% for some distributions if they're taken before age 59 ½.

Types of Annuities

When buying an annuity, you're trading a lump sum of money in return for a stream of income, but annuities come in many flavors, which can make them confusing.

The two major categories of annuities are "immediate" and "deferred."

With an immediate annuity, payments to you start immediately or within one year of the policy's issue. You use this type when you want to start taking income as soon as possible.

A deferred annuity has two phases. During the accumulation phase, you defer those income payments, letting your money grow on a tax-deferred basis for several years.

Then there's the payout phase, when you start receiving scheduled payments.

There are a few types of deferred annuities to consider:
  • Fixed annuity. The insurance company agrees to pay you no less than a specified rate of interest during the time your account is growing. It also agrees that the periodic payments will be a specified amount per dollar in your account. These payments may last for a definite period, such as 20 years, or an indefinite period, such as the lifetime of you and your spouse.
  • Variable annuity. If you want more access to more investment options, you can choose from among a range of them, typically mutual funds, to invest your purchase payments. The rate of return on your payments, and the amount you eventually receive, will vary depending on the performance of the investment options you have selected.
  • Indexed annuity. A blend between a fixed and a variable, where the insurance company invests in a mix of stocks and bonds designed to credit you with a return based on changes in a particular index, such as the S&P 500 (INDEXSP:.INX). In a falling stock market, indexed annuity contracts guarantee a minimum return, typically three percent.

The Pros and the Cons of Annuities

Regarding immediate annuities, guaranteed income for life is a great benefit, but it comes at a cost. First, you're giving up access your money in exchange for the income stream.

Therefore, your wisest move is to invest with only a portion of your total portfolio.

Additionally, most immediate annuities provide for fixed payments, which aren't adjusted for inflation.

While we may be in a low-inflation environment today, what happens if prices rise substantially during your annuity's payout period?
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