When planning your estate in order to protect yourself and your loved ones, there are good reasons to include an annuity. Annuities allow you to guarantee a source of income for yourself, but they can also be used in order to pass funds on to beneficiaries.
What Is An Annuity?
An annuity is an insurance contract you can purchase for the purpose of receiving guaranteed income or for retirement planning. In exchange for making a lump-sum or series of payments, you receive regular disbursements on an arranged schedule. They can pay out immediately or sometimes in the future. Annuities that pay in the future are referred to as deferred annuities.
There are three main types of annuities.
- Fixed
- Variable
- Indexed
Each type of annuity has a varying degree of risk and payout potential. As far as taxes go, income received from an annuity is subject to income tax. Long-term capital gains tax rates are usually lower. So, you may want to consider discussing your investment plans with a financial advisor or CPA.
Related reading: Estate Planning Basics
Benefits Of Buying Annuities
1. Guaranteed Income
This is perhaps the number one reason that people purchase an annuity in the first place. It acts as insurance to protect you from outliving your assets. It is not uncommon, and it is becoming more common, for people to outlive their retirement funds. This is the result of longer lifespans.
It might sound funny to purchase insurance for living a longer life, which is really a blessing. But, it makes good financial sense. When you purchase an annuity, you are guaranteed to receive funds until the day that you die. So your family will not have to start spending their own money in order to support you.
On top of this, you can purchase a joint annuity that will protect your spouse if you die. You can also purchase annuities that will continue to pay your beneficiaries if you die until your assets run out. Or for a specific number of years.
2. Safety
Annuities are not subject to the fluctuations of the economy, at least to a certain degree. Fixed annuities do not change, which is great. Indexed annuities and variable annuities can change their interest rates somewhat as a result of changes in the economy or if they are linked to other investments, but the principle is safe.
There is no chance that the funds will be lost as a result of a downswing in the economy. In the case of an annuity with a fixed income rate, in fact, the annuity will continue to gain value regardless of the fact that the economy has taken a turn for the worse.
3. Tax Deferral
Unlike a great deal of other investment choices available, the interest that you earn from an annuity is not taxed while the annuity is going through its growth period.
This means that the assets grow much faster than they do with other investments. In addition, this also means that a straightforward comparison of interest rates between an annuity and a certificate of deposit or other investment is not necessarily accurate.
Taxes have to be taken into account as well. Growth is much faster with an annuity.
4. Privacy
When you set up an annuity, you set up a contract between you and the insurance company. When you do this, you also eliminate the need to declare anything in your will.
You can name beneficiaries in the contract, so that this information does not need to be revealed in public when your will is read.
In addition to this, an annuity allows probate to be avoided. This means that there are no delays before the beneficiary starts receiving the funds. And there are no additional taxes that need to be paid as a result.
5. Liquidity
While an annuity might not be as liquid an investment as stock in a company, there are some misconceptions about just how liquid the investment is.
Many insurance companies will allow you to withdraw as much as 10 percent of your funds without facing any penalties, which can't be done with CDs or treasury bonds.
Consider Annuities In Your Estate Planning
Annuities are potentially a great financial instrument to guarantee you never run out of money. You'll have to pay a lump sum up front. But, the guaranteed returns are worth it for many people.
Further Reading
- The Importance Of A Revocable Living Trust
- The Most Amazing Estate Plan You’ll Ever Read
- Fixing Our Absent-Minded And Forgetful Selves
- How Not To Panic During A Stock Market Correction
- The Multi-Year Guarantee (MYG) Annuity
For more resources check out my:
- Top financial products page to find the best products for your finances
- Invest in real estate page to invest in my favorite asset class,
- Free wealth management page to manage your money better.
Financial Samurai has been online since 2009 and is one of the most trusted and largest independently-run personal finances today.
Don't Forget To Buy Life Insurance
Life insurance should be an integral part of your estate planning process. A life insurance payout is usually tax-free and serves to financially support your loved ones after you're gone.
Check out Policygenius, my favorite insurance marketplace where you can get free customized life insurance quotes from top carriers. When insurers compete for your business, you win! Both my wife and I bought matching 20-year life insurance policies during the pandemic and felt tremendous relief after. Now our kids are protected until they are 22 and 25, respectively.
Annuities can a beneficial part of estate planning in some circumstances, but it is important to figure out goals before making a long term commitment.
I think annuities are a great addition to a complete retirement plan. Most retirees won’t benefit from a guaranteed source of income (besides Social Security). This is why using a part of your cash to purchase an annuity is a good idea to reduce your risk.
On the other side, putting all your money in annuities might not be a good idea since the money is locked-in. There are riders allowing you to withdraw additional amount on top of your monthly payments but keep in mind that each time you add a rider (an option) to your contract, there is a cost attached to it.
I’m not convinced variable annuities (with money invested in mutual funds) are great considering costs attached to it. What do you think about variable annuities?
An immediate annuity can solve many of your income needs. The unique guarantee, security and flexibility offered by an immediate annuity make the product an ideal financial solution for many situations. For example, if you’re searching for an easy way to manage your retirement income, an immediate annuity can relieve your financial concerns with a simple one-time premium. Or, if you have a qualified plan and want to retire early, an immediate annuity can help you avoid early withdrawal penalties.
I think annuities can be a very important part of an overall portfolio, but I think a lot of people get suckered by these products and their salesmen who are looking for the biggest commission possible.
These contractual products can really get people into trouble if they are not 100% sure about what it all means.
However, the security that a guaranteed stream of income can provide can be very valuable!
I think that’s very true, too.
The best deal, in my opinion, is the immediate annuity. Otherwise you get whacked by fees during the accumulation period.
Annuities as a concept are a great idea. In practice they are generally misunderstood by the investing public. Many issues to consider when looking at annuities which include: The strength and overall quality of the insurance company; the fee structure; the underlying investments; the annuitization schedule. When dealing with an annuity sales person you should not be afraid to ask him/her tough questions. Among the questions should be why aren’t you showing me low cost, no or low load products vs. this high expense “garbage?”
Indeed, don’t be hesitant to ASK QUESTIONS! Annuities are great for some, not for others. Question, ask, question!
Yes, if the insurance company goes Bankrupt, the holder is SOL.
I agree with that for sure- absolutely ask questions. Also make sure the insurance company you invest with is authorized and pays into a guaranty fund.
However, it is untrue that the annuity holder is SOL if the insurance company goes bankrupt.
Federal and State regulators keep a very close watch (and reign) on these firms, hence the failure of an insurance company is a rare occurrence. Strict laws governing authorized Insurers require that they keep a very large percentage of their assets in safe instruments, such as U.S. Treasury Bonds and pools of cash designated for future payouts and claims. These investments cannot be used for the day-to-day financing of the company or for any other purpose.
Now even if an insurance company does go bankrupt, they have up until that point been paying into State regulated insurance guaranty funds. These are basically insurance for insurance companies. They exist to cover client’s losses up to a certain amount (or in this case. the client who owns an annuity with that company). Therefore, make sure that whatever insurance company you contract with is authorized and pays into a guaranty fund.
I believe all states cover the first $300,000 of a loss and most guarantee a substantially larger amount. Basically, losing all expected income from a lifetime annuity is not something to lose sleep over. There is an incredible chance the investor will recoup everything even if their current insurance company goes under.
OK, good to know and very helpful. Although, I should hope it’s more than $300,000 guarantee and more like $3 million, b/c nobody bothers buying a $300,000 annuity since that would only yield $12,000 a year at 4%.
Annuities never really make the news or finance classes. I think that’s why a lot of people including me aren’t that familiar with them. The part about privacy and being able to list beneficiaries for assets not listed in a will is an interesting feature. I don’t have anything that’d really benefit from that feature but it’s good to know.
@krantcents
@Sunil from The Extra Money Blog
You guys might be right. It’s best to just ask your local financial advisor/wealth management division of your bank and ask them about the specifics of annuities.
I would have totally invested some of my assets in annuities, but the issue is if I had to, I think I can work easily for another 20 years, so I do have income coming in and I want to be liquid, liquid, liquid. There are penalties for taking money out of annuities that are stiffer than CDs.
@Darwin’s Money
Good point. A trusted adviser is important, if you can find one to let them handle everything for you.
krantcents nailed it. most people do not consider these because they don’t know what they are and how they work. learning takes time and initiative, and the inertia is hard to overcome
For people that aren’t comfortable managing their own finances and don’t want to pay an advisor every year, might be a good choice if they can get one w the right fee structure.
Financial products like annuities remain a mystery for too many people. Thank you for the explanation! Annuities can be the fixed income portion of your retirement.