Annuities can be a good way to ensure a steady stream of income in retirement if -- and that's a big IF -- you choose the right kind for your needs.
There are a whole range of products labeled annuities, and some are much better than others. But sales people continue to tout both the good and bad (see An Annuity You Really Should Avoid). So you need to be really careful before you jump into an annuity.
How an annuity works
An annuity is an insurance product. With an immediate annuity, you give an insurance company a lump sum and received fixed monthly income for the rest of your life. With a deferred variable annuity, you invest in a mutual fund-like account and the insurance company guarantees future payouts. Annuities also have a death benefit (this is where the insurance comes in) that entitles your beneficiary to the value of your annuity or a guaranteed minimum, whichever is greater.
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But there are lots of twists to deferred annuities. You can't withdraw the money until you're 59½, or you'll be hit with a 10% penalty on earnings. Plus, you'll pay a surrender fee if you tap the annuity before a certain period laid out in the contract (usually seven years).
Other drawbacks: Earnings are taxed as income rather than at the long-term capital gains rate. And annuities usually charge more than 1% a year for the death benefit, but it pays off only if you die when your account has fallen below the minimum guarantee. If you want a guarantee on a deferred variable annuity that you won't lose money even if the underlying investments decline in value, you'll likely have to pay fees of 2.5% to 3% per year.
How to pick the right one
In large part, whether you pick an immediate or deferred variable annuity depends on whether you're already retired or are still saving for retirement. Immediate annuities are better for retirees who want to receive payouts right away. Read more about this type of annuity. Deferred variable annuities are better for preretirees who want the potential for their account value to increase. Read more about this kind of annuity.
Take our ten-question quiz to learn even more about annuities and to find out which type is right for you. And our Understanding Annuities special report loads of information and strategies for using annuities to create a steady stream of income in retirement.
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