In recent years, annuities have developed a fairly negative reputation, and while they aren’t for everyone, adding one to your retirement portfolio can be a really good idea. Unfortunately, there are many misconceptions about these financial products, keeping many potential buyers at bay, often times unnecessarily. It’s always recommended that you do your homework before purchasing any retirement savings tool, and annuities are no exception. Before entering into a contract, be sure to thoroughly understand what it is that you are buying, and discuss any questions or concerns with a trusted financial advisor. To get a head start on your annuity education, here’s a look at some of the more common misunderstandings, courtesy of news outlet, Madison.com.
Myth #1: Purchasing an annuity now will help me save money on taxes immediately.
One of the perks of putting your money into a 401(k) or traditional IRA is that you do so on a pre-tax basis. This means that if you put in $5,000, you don’t pay taxes on the year you contribute. Annuities don’t work that way. When you buy an annuity, you use after-tax dollars, which doesn’t lower your tax liability at the time. But even though you can’t fund an annuity with pre-tax money, that doesn’t mean there aren’t tax benefits. Your investment can grow on a tax-deferred basis, meaning you won’t pay taxes on your gains until the time comes to actually take withdrawals.
Myth #2: I can access my money at any point in time.
You may be familiar with traditional IRA or 401(k) penalties, typically 10% if you withdrawal before you reach 59 ½ years old. The same holds true for annuities in this case. Unless you qualify for an exception (like becoming permanently disabled for example), early withdrawal from an annuity will most definitely end in some sort of penalty.
Myth #3: Withdrawals in retirement will not be taxed.
When you consider that annuities are funded with after-tax dollars, it’s easy to understand why you might think that you wouldn’t have to pay taxes when the time comes to withdraw your money. But this is only partially true. Annuity products are typically taxed on what’s known as a last-in, first-out basis. This means that when you withdraw from an annuity, the money that initially comes out is considered earnings on your investment, and is taxed as such. But, once you’re done withdrawing your earnings, and the value of your annuity falls below what you paid in premiums, your withdrawals will no longer be subject to taxes.
Myth #4: It’s wise to hold an annuity within my IRA.
When you open an IRA, you are responsible for deciding on how to invest that money. While some might think it’s a good idea to invest it in an annuity, there are actually few financial benefits. The primary advantage of an annuity is the ability to grow your money on a tax-deferred basis. IRAs already offer this benefit, making an annuity a bit redundant. However, if you’re close to retirement and are worried about not having enough money to cover living expenses, it might make sense to use a portion of your IRA to purchase an immediate annuity. This product is purchased with a single payment and guarantees a stream of income for a preset period of time. It might be 10 years, 20 years, or as long as you live. And because payments begin right away, your concern about outliving your savings is releived. For some, it’s an option worth considering.
Myth #5: If I change my mind, I can cancel my anuity purchase.
The only way you can back out of an annuity contract is if you do so within the surrender period. Most annuities allow cancellation within a short window, usually 10 to 30 days of the completed paperwork. Once this period passes, you are locked in to the contract. Cancelling after the surrender period is over will result in a substantial fine, generally 7% during the first year of the contract and decreasing 1% annually after that. You can typically avoid the charge if you take out a small portion of your annuity, but a withdrawal greater than 10% will result in a charge. Of course there are some exceptions, such as falling terminally ill or being confined to a nursing or long-term-care facility.
Again, it is always recommended to do some research, ask some questions and read the fine print before signing on the dotted line of an annuity contract. It is true that they are complex products, however it is worth taking the time to learn about them. If right for you, annuities are a great way to generate retirement income.
Written by Rachel Summit