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September 2, 2014
Should you buy an annuity? Investing your capital and planning for retirement are important practices, but there are a ton of options out there for how and where to park your money to realize potential growth in the future. Simply put, an annuity is a contract between you and an insurance company. You essentially give the company a certain amount of money, and in return you are promised a monthly payout for the rest of your life.
While there are plenty of cases where an annuity makes sense, it may not necessarily be for everyone, which is why there are certain questions you should ask yourself and your agent before purchasing one.
1. What is the purpose of my investment?
This is potentially one of the most important questions to ask yourself before you purchase an annuity. It’s crucial that you are clear about why you want to purchase an annuity, and the real benefits that you will receive. Annuities are not for everyone – they are essentially meant to offer investors reasonable growth and the potential for sustainable income in retirement years, and are not meant to be tapped into on a regular basis. For those with more complex financial situations that require a higher level of liquidity, an annuity may not necessarily be the right choice.
2. What kind of annuity am I buying?
Deferred? Immediate? Fixed? Variable? These are just some of the wide variety of annuities that can be purchased. And in addition to choosing the right type of annuity, you need to make sure that you purchase the right kinds of riders. Riders are provisions to an insurance policy. Each rider generally incurs an additional cost.
Examples of annuity riders that you will want to consider include:
3. How much will this contract cost me each year?
The more money you are promised on your annuity contract, the higher the costs will be. A deferred annuity contract typically comes with the following expenses:
4. What is the ‘Surrender Period‘, and what are the penalties if I want to end my contract early and withdraw all of my money?The surrender period on an annuity contract is the period of time that an investor must keep the annuity contract with an insurance company without paying fees on too may withdrawals. Some amount of distribution is typically permitted on an annual basis without being penalized with an additional charge. Any withdrawals that are made over these stipulated amounts are typically subject to penalty fees, which can range between 5 to 15 percent of the amount withdrawn. The purpose of a surrender period is to allow insurance providers to earn higher yields on investments. An annuity isn’t meant for short-term investments or a source of money, which is why it’s important to find out the specific rules regarding withdrawals.
5. How is the income from my annuity going to be taxed?Taxes are complicated and you should probably ask your annuity provider, an accountant or a financial advisor about your particular situation.
Generally — depending on the annuity type, you can purchase an annuity with money from your IRA, and if pre-tax money from a 401K or IRA is used to buy the annuity, all payouts will be fully taxed. If after-tax dollars are used to purchase the annuity, however, a portion of the payouts will be a tax-free return of your principal amount. Regardless, you’ll be subject to taxes that are owed on the annuity at the ordinary income-tax rate, and not at the capital-gains rate.
6. Will the insurance company issuing the annuity keep its promises?In order to determine the likelihood that the insurance company will make good on its promises, it’s critical to check out their credit rating. Insurance providers are rated by Standard and Poor’s, as well as AM Best, Fitch, and Moody’s. Moody’s, Fitch and S&P rate insurance companies between AAA and A. AM Best ranks companies as A++ and A+. It’s in your best interests to purchase an annuity from an insurance company who has received top ratings. Buying an annuity is a big financial promise, so it’s wise to buy only from a larger, more reliable company.Any investment is a huge financial commitment. It’s crucial that you do your due diligence and ask the right questions before jumping into an annuity investment.
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