Understanding the Role Annuities Can Play in Your Financial Plan

Many people feel comfortable discussing popular investment options like mutual funds, CDs, Treasury bills, bonds, and even cryptocurrencies, but annuities often seem more mysterious. Although not ideal for everyone, in reality, an annuity can be an effective component of some individuals’ financial or retirement plans — especially for those seeking a source of guaranteed income later in life.

An annuity is often categorized as a form of insurance rather than a traditional investment. When you purchase an annuity, you can choose to pay either a lump sum or a series of premiums, in exchange for guaranteed payouts in the future. The primary goal of an annuity is to reduce the risk of outliving your money. 

When purchasing an annuity, those payments can either start right away or at a later date in the future:

• Immediate Annuities
• With an immediate annuity, payments to you begin right away (or within a short time period, typically within 12 months).
• These can be a good fit for retirees who are ready to receive income immediately after making a lump-sum payment.

• Deferred Annuities
• A deferred annuity postpones payouts until a specific date in the future — often many years down the line.
• This approach can allow earnings to build over time on a tax-deferred basis, which may be beneficial if you do not need income right away.

Within the categories of immediate and deferred annuities, there are three main sub-types to consider:

• Fixed Annuities: Offer a guaranteed interest rate for a specified period. The insurance company assumes the investment risk, and you receive a predictable return.
• Variable Annuities: Allow you to invest in underlying sub-accounts (often similar to mutual funds). Your payments or contract value can fluctuate based on the performance of those investments.
• Indexed Annuities: Typically link potential returns to the performance of a market index (e.g., the S&P 500) while also providing a minimum guaranteed rate of return. The exact growth formula and rate guarantees vary by contract.

Annuities come in many forms, and each one may have unique features. However, there are several broad benefits often associated with them:

• Guaranteed Income
• One of the most attractive features of annuities is the promise of a steady income stream. Depending on the contract, payments can last a set number of years or for the rest of the annuitant’s life.
• Tax Deferral on Growth
• Once you’ve purchased an annuity, any growth (interest, dividends, or investment gains) inside the contract is typically tax-deferred.
• Unlike 401(k)s or IRAs, annuities generally do not have specific annual contribution limits, which can make them appealing to high-income individuals looking for additional tax-deferred growth.
• Asset Protection and Probate Advantages
• In many states, annuities (particularly certain types) receive protection from creditors, treating them similarly to retirement accounts.
• Annuities can also bypass probate when you have designated a beneficiary, potentially saving your heirs time and money.
• Possible Financial Aid Benefits
• If you are not yet drawing income from an annuity, its value may be excluded from the Free Application for Federal Student Aid (FAFSA), potentially helping your child qualify for need-based financial aid. This exclusion can vary, however, so it is important to review the latest federal guidelines or consult with a financial aid expert.

Despite their advantages, annuities can have distinct drawbacks. It is essential to understand these issues before deciding to purchase one.

Annuities can serve as a valuable tool for certain investors—particularly those seeking a guaranteed income stream to hedge against longevity risk. The tax-deferred growth potential and protections some annuities offer may also be appealing. However, the complexity of annuity products, combined with potentially high fees and tax implications on withdrawals, means they are not a one-size-fits-all solution.

If you are considering an annuity, it is wise to:

• Consult a financial advisor or other professional who can evaluate your overall financial picture and retirement goals.
• Compare different contracts and request detailed illustrations and fee schedules.
• Review your timeline to ensure the surrender periods and distribution dates align with your needs.

By weighing the advantages and disadvantages carefully, you can decide whether an annuity is an appropriate part of your long-term strategy.