An annuity is an insurance product that can help you save for retirement or pay expenses in retirement.
You can get guaranteed* income for life from an annuity, a benefit that's typically available only through a pension. This lifetime income can help you reduce the risk that you'll outlive your savings.
Annuities can offer investment portfolios, or they can provide a fixed interest rate to help build your savings and reduce the chance of a financial shortfall in retirement. You can buy an annuity through a variety of financial firms, including insurers and mutual fund companies.
* Subject to the claims-paying ability of the insurance company.
There are two major categories: deferred annuities and income annuities.
Deferred annuities—to help you save for retirement
You can use a deferred annuity to help build your long-term nest egg. You get to defer taxes on earnings until you withdraw, and you also have the option to convert your money into a stream of lifetime payments.
A deferred annuity can be variable or fixed.
Income annuities—to help you pay expenses in retirement
You can use an income annuity (also called an immediate annuity) to meet your spending needs in retirement and to reduce the risk that you'll outlive your money.
In return for an upfront payment, you get a stream of income guaranteed by the insurance company. The income can last for as long as you're living, as long as either you or your spouse is living, or for a specific number of years. Your payments can be fixed or can vary depending on the performance of underlying investments.
The level of payment you'll receive depends on:
Is an annuity right for me?
That depends on your goals, how comfortable you are with investment risk (for a variable annuity), and the type of annuity you're considering.
Saving for retirement—deferred annuity considerations
Financial advisors usually recommend that you consider a deferred annuity only after you've contributed the maximum to other tax-favored retirement accounts, such as 401(k)s and IRAs. That's because annuities typically have higher costs than other retirement savings options.
Points about taxes:
Spending in retirement—income annuity considerations
An income annuity may be right for you if you want cash flow in retirement and you're concerned about outliving your savings. The annuity can deliver a steady stream of payments for as long as you're living, for as long as either you or your spouse is living, or for a specific number of years.
The purchase of an income annuity is generally irrevocable, so use only part of your savings if you choose to buy one.
What are the advantages of an annuity?
Similar to an IRA, a deferred annuity lets you save for retirement and put off taxes on your earnings until you make withdrawals. By deferring taxes, you can enhance compounded earnings growth and potentially end up with a bigger nest egg.
Advantages of a deferred annuity compared with an IRA:
On the other hand, an advantage of an IRA compared with a deferred annuity is that you may be able to take a tax deduction for money you contribute to an IRA. You generally can't take a deduction for a contribution to an annuity, unless you hold it in an IRA. But be aware that if you hold an annuity in an IRA or another "qualified" retirement account, you would be subject to IRS contribution limits and required minimum distributions.
Other advantages of a deferred annuity include:
An income annuity offers you a way to get cash flow after you retire and to help protect against the risk that you'll outlive your savings. If you choose a fixed income annuity, you can get stable payments for life and have confidence that your income is guaranteed by the insurance company.
What are the disadvantages of an annuity?
Variable deferred annuities generally have higher costs than other retirement savings vehicles, like IRAs and 401(k)s. Some variable annuity providers also charge withdrawal penalties, called "surrender charges."
You'll need to hold the annuity for many years to allow time for the benefit of tax deferral to outweigh the higher expense. You're also assuming investment risk with a variable annuity, so you could lose money.
Fixed deferred annuities carry interest rate risk, meaning you can miss a rise in interest rates because you're locked in at a lower rate for a certain period. In addition, you may have to pay surrender charges if you take withdrawals before the fixed deferred annuity reaches maturity.
Once you've bought an income annuity, it can be canceled only in very limited circumstances. The insurance company invests your money and provides periodic payments, but you no longer have access to your original purchase amount. So it's important that you have additional liquid assets for emergencies and other expenses.
How do I take money out of an annuity?
You can withdraw money from a deferred annuity, but you may have to pay surrender charges and, if you're under age 59½, the IRS can impose a 10% penalty tax.
Another option is to "annuitize," converting the deferred annuity into an income stream. Your assets go to the insurance company and, in exchange, you get periodic payments guaranteed by the company. Before you annuitize, you want to make sure that it's right for you because the decision is generally irrevocable.
With an income annuity, you receive periodic payments (usually monthly) but otherwise have no access to the money you used to buy the annuity. You can't make withdrawals.
Can I move my annuity to another company?
You can move a deferred annuity through a tax-free transfer known as a 1035 exchange. Switching to a company with lower annuity costs can lead to substantial savings.
Before you transfer, check with your current company about surrender charges you may have to pay. Other factors to consider include fees, the financial strength of both companies, and your death benefit options.
Vanguard's licensed specialists, who don't work on commission, can provide unbiased assistance to help you evaluate a potential exchange of a deferred annuity.
You can't transfer an income annuity.
Variable annuities are long-term vehicles designed for retirement purposes and contain underlying investment portfolios that are subject to investment risk, including possible loss of principal.