Understand How an Annuity Works
The easiest way to understand an annuity to is to think of it as the opposite of life insurance. An annuity pays when you are alive; life insurance pays when you die. More formally, an annuity is a contract between an individual and the insurance company. In exchange for either a single deposit or a series of deposits you make into your annuity, the insurance company promises to make a series of payments to you out of the annuity — payments you can use to supplement your income after you retire.
The earnings in the annuity accumulate on a tax-deferred basis and then, at some date in the future, you begin to receive payments, either a lump sum or at regular intervals, monthly, quarterly, bi-annually, annually, for a specified period of time, usually between 5 to 30 years — or — for life.
Determine Your Priorities
While tax deferral makes annuities attractive, they may not necessarily be your first course of action. You may want to consider an annuity after you have fully funded your employer's (tax-qualified) retirement plan such as a: 401(k), 403(b), SEP, or SIMPLE IRA or your own IRA for the year. These plans use pretax money and are generally the first step in establishing your long-term retirement strategy. *
Here are a few rules of thumb:
- If you have additional funds to invest, annuities — along with other investments such as mutual funds, bonds, and stocks — may be an option. All of these can be present in a well-rounded retirement strategy.
- If you need immediate access to your money, a deferred annuity may not be the best option since it is generally considered a long-term investment product. However, if you have extra liquidity and a long-term savings goal, the benefits of tax-deferred growth could make a deferred annuity an excellent choice.
- If you need a steady stream of income right now, you may want to consider an immediate annuity.
*Tax-qualified plans (like a 401(k), 403(b), SEP IRA and SIMPLE IRA) already provide tax deferral under the Internal Revenue Code, so the tax deferral of an annuity does not provide any additional benefits. Also, variable annuities are subject to additional fees to which other tax-qualified plan funding vehicles may not be subject.
When Selecting Your Annuity
Check Out the Annuity Charges and Fees Before Buying
To receive the benefit of tax-deferred growth in a deferred annuity, you may have to sacrifice some liquidity, in the form of potential penalties from the IRS for early withdrawals and withdrawal charges or other fees from the insurance company for canceling the annuity contract or withdrawing funds within a certain number of years.
The IRS can impose a penalty of 10% for withdrawals made before age 59½. Withdrawal charges for most annuities can start at 7% for the first year and decline by 1% each year until they disappear, usually after year eight. These charges serve to underscore the long-term nature of deferred annuities, whether variable or fixed. There are annuity contracts that do allow you to withdraw 10% annually without incurring any withdrawal charges, so be sure to check the contract or prospectus before making any withdrawals from an annuity.
Some annuities may have a front-load fee (fees subtracted from your annuity when you first purchase the contract) or yearly maintenance fees. Make sure you are aware of all the fees associated with an annuity before making any purchase.
Consider the Reputation and the Quality of the Company
An annuity is only as good as the company that backs it. You want to know for certain that the company that issues your annuity will be around to make payments. There are several ratings agencies that rate insurance companies on the quality of their fiscal fitness, quality of investments, and overall financial soundness. A credit rating represents an independent assessment of the insurer's ability to pay its claims on time and meet all its other financial obligations, the bottom line for any life insurance company. There are four leading agencies: A.M. Best, Standard & Poor's, Moody's, and Fitch Ratings.
The guarantees in an annuity are backed solely by the claims-paying ability of the insurance company, and should be a key consideration in making your purchase decision.
Consult Your Northwestern Mutual Financial Representative
One of the best ways to determine if an annuity is a good fit for your situation is to sit down for an in depth conversation with your Northwestern Mutual financial representative.
The service your representative provides is invaluable. All relevant personal information will be factored into a retirement solution that is right for you, terminology will be explained, and you come away knowing exactly what an annuity will provide for you.
Furthermore, your representative will be available to reassess your retirement strategy as your needs evolve over time. In other words, your Northwestern Mutual financial representative can guide you through a lifetime of financial decisions.