There are several options to choose from when planning your retirement strategy. Depending on where you work, you might be eligible to participate in an employer-sponsored plan, such as a pension fund. If not, you may have to look for other ways to stash away cash for retirement. An annuity can provide you with a steady stream of income in your golden years, but there are several things to consider before you purchase one.
There are two basic types of employer-sponsored pension funds: defined benefit plans and defined contribution plans. With a defined benefit plan, your employer kicks in money on your behalf, and the amount you receive at retirement is based on your age, years of service and salary. Some defined benefit plans may also allow employees to chip in cash through elective deferrals. With a defined contribution plan, you're responsible for funding your account. The size of your nest egg ultimately depends on how much you put in, what your employer matches and how well your investments perform. Examples of defined contribution plans include 401(k)s, 403(b)s and profit-sharing plans.
An annuity is a financial product that you can buy from an insurance company. You give the insurer a specific amount of money, and in return, they promise to pay you a set amount of benefits in the future. Annuities can be fixed, variable or indexed. A fixed annuity means you'll get the same amount each month. A variable annuity means your monthly benefit fluctuates based on how well your investments perform. Indexed annuities are typically tied to a stock index, like the S&P 500. Depending on your needs, you can set up the annuity to receive lifetime payments or to pay you for a set period of time.
Any money you receive from a pension or annuity is generally taxable at your ordinary income tax rate. The payments may be fully or partially taxable, depending on how they were funded. For example, your pension benefits would typically be fully taxable if you didn't contribute anything to your account. If you used after-tax dollars to buy an annuity, then you wouldn't have to pay taxes on the part of your benefits that represents the amount you originally invested. If you start receiving benefits from a pension or annuity before you turn 59 1/2, you may have to pay a ten percent early withdrawal penalty on the money.
Annuities can provide you with retirement income, but they can be expensive. There are a number of costs associated with these products, including commissions, annual fees and surrender charges that could significantly reduce the value of your investment over time. The fees tend to be higher than what you would pay if you purchased stocks or bonds, and annuities may not perform as well.
In some cases, an employer could choose to freeze or terminate a pension plan, which could affect your savings strategy. If your plan is frozen, you won't be able to contribute any more money. If it's terminated, you'll receive your benefits but will have to roll them over to a new retirement plan to defer taxes.
- Photodisc/Photodisc/Getty Images