An annuity is a type of retirement savings investment in which you make an investment or periodic payments with an insurance company, and then the company provides you with income payments on a pre-set schedule. Certain annuities are sometimes labeled as "tax free" because income earned on annuity accounts is tax deferred, although income may be taxed when withdrawn.
One of the most important advantages of annuities for retirees is that they can provide a predictable source of income that persists throughout retired life. Annuities can be set up to provide fixed income payments until the purchaser's death. This can be especially beneficial to people who live a long time in retirement. People who live longer than they expect can get into financial trouble when savings and other investments disappear, but annuities can continue to provide income. Annuities can be either fixed or variable, but even variable annuities will pay income, even though the exact amount paid may depend on underlying investments.
Another advantage of annuities is that they are very secure investments. The main threat to an annuity is the financial health of the insurance company that issues them. If an insurance company happens to go under, there are protections in place for annuity holders. States back require annuities to be insured up to certain minimum levels, similar to FDIC insurance on savings accounts, and annuity holders may be required by law to be paid off before stockholders and other obligations the insurance company may have.
Tax-free annuities are not technically "tax free," but contributions can be tax deferred until the time of withdrawal. Deferred annuities allow you to make an initial deposit that appreciates over a predetermined span of time before any withdrawals are made. This deferral of taxes can allow savings to grow more quickly, resulting in more income when withdrawal payments are made. One of the main drawbacks of annuities is that you forgo the opportunity to invest in other things, like stocks, which may earn income faster than an annuity.
Perhaps the largest drawback of annuities are the finance costs and other fees. Getting and maintaining an annuity may require administration fees and other sales fees that can sap income, and make the annuity less desirable than other retirement savings accounts that have lower costs. High fees charged can negate the income benefits gained from tax deferral.
It can be a hassle to get money out of an annuity quickly. If you face a sudden need for cash, its much easier to sell stocks from a brokerage account than it is to liquidate a portion of your annuity. The quickest way to access annuity money is to borrow it, but this isn't allowed in an individual retirement annuity.
People in poor health will likely gain less benefit from an annuity, since they may not live long enough to receive many income payments. If you expect to live only a few years, you could have a much greater amount of income by simply using the money that you have saved up instead of using an annuity. The main risk is using money too quickly or expecting to die too soon. Annuities provide a way to guard against this uncertainty.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.