Are Annuities a Good Idea for Retirement? (5 Benefits and 3 Drawbacks)

At its most basic, an annuity is a contract you sign with an insurance provider. You provide money up front, either in a lump sum or through payments over time, and in exchange, the insurance provider gives you a stream of payments at a later date, either monthly, like a pension, or as a lump sum.

Annuities get a lot of attention in the financial world. It seems people either love them or hate them. While they can be helpful tools for some, knowing what you're getting into before signing on the dotted line is vital.

Let's look at some standard features to help you decide if an annuity might be a smart money move for you.

A variable annuity is a contract where the insurer agrees to make periodic payments to you. You can purchase an annuity in a lump sum or with recurring payments. Variable annuities have rates tied to a selected portfolio and may fluctuate based on what the market does.

The initial investment is held in sub-accounts similar to mutual funds. You can choose to invest in stocks, bonds, money market accounts, or some combination of the three, and your rate of return is based on the performance of the market.

A fixed annuity is similar to a variable annuity, except the agreement usually offers a guaranteed rate of return based on the investment yields the insurer holds, like bonds or other fixed-income investments.

State insurance commissioners regulate fixed annuities. It's essential to check with your state insurance commission to understand the details of fixed annuities and confirm that your insurance broker is registered to sell them in your state.

Indexed annuities mix features of both variable and fixed types. They usually offer a minimum rate of return but also provide a rate tied to the movement of a specified stock index like the S&P; 500. Indexed annuities may or may not be considered a security, and most aren't registered with the U.S. Securities and Exchange Commission (SEC).

There are generally two phases to an annuity product. The accumulation phase is when you, as the purchaser, make payments to the insurance company, called your principal, and earmark it toward one of the indexed investment options. The insurance company credits your account based on the performance of the fund.

The annuity phase is when the carrier makes a periodic payment of your investment growth and some principal. The period is usually monthly, but depending on how the contract is written, you may be able to receive a lump sum.

One of the main selling points of an annuity is the dependable income in retirement. If you don't have access to an employer pension plan or are worried that your retirement funds will run out before you pass away, an annuity might be a good option since it could mean guaranteed income.

Annuities can also help you plan for retirement because you'll know what income to expect every month, regardless of your other savings. Be cautious, however, since some annuities only pay out for a certain period, and you may outlive the income.

Depending on the type of annuity you purchase, you may receive a guaranteed rate of return, meaning the insurance company will bear all of the investment risks, and your principal is more protected from changes in the market.

A guaranteed rate of return is most common for fixed or indexed annuities. Variable annuity rates fluctuate with changes in the market and your rate of return may decline if the market falls.

A guarantee can provide peace of mind for your retirement income, but make sure you understand what you've purchased and any fees or penalties included in your contract.

Annuities might seem like a great way to save for retirement since you can essentially buy a retirement income for yourself and your spouse. Depending on the way annuities are written, you can receive payments for a set period, for the rest of your life, for your spouse's life, or a combination of options.

Remember that, like Social Security benefits, the sooner you start taking payments, the smaller your amount will be since it likely has to last longer.

While survivor options may differ based on the type of annuity and contract you have, many may offer a survivor option for the contract holder's spouse or heirs. These can be options for a spouse to continue to receive payments after the contract holder's death, or it may be a way for people to leave an inheritance to their children.

A death benefit rider may allow the insurance company to return any unused premium payments to your estate if you die before the entire premium value is used.

Unlike CD accounts, which require you to pay taxes in the year that you earn interest on the certificate, money in an annuity generally grows tax-deferred.

Any gains made on the initial investment grow tax-free until the annuity phase, when you receive payments. The tax rules may differ if you have a qualified annuity (like those held in an IRA or other retirement account), so consult a professional.

You can also transfer money from one investment type to another within a variable annuity without paying taxes, although when you start receiving payments from your annuity, your money will be taxed as ordinary income. Work with a tax professional to help you understand the tax implications of any annuity you are considering.

Annuities tend to have higher fees and costs than other investment options like mutual funds or CDs. However, they may be built into the policy, so you aren't as readily aware of them.

If you purchased an annuity through an insurance agent, you might pay a commission or other upfront costs that other investment options may not have.

It's also important to note that each time you add a rider, which is an additional coverage or benefit added to the original contract, you will likely pay additional fees.

Although your money can grow tax-free during the accumulation phase, once you start receiving monthly payments, your net returns will be taxed as regular income. If you're in a higher tax bracket, you may be paying much more in income tax than you would for capital gains tax.

For this reason, when you consider an annuity versus an IRA or other retirement accounts, you may want to focus on different retirement accounts first and consult a tax professional to help you understand the implications of an annuity in retirement.

Like with many investments, annuity contracts come with a surrender fee, which may be imposed if you try to withdraw your principal funds before an agreed-upon date. Many surrender periods last between six and eight years or possibly longer.

Surrender fees are usually a percentage of the amount withdrawn and decline over a set period. For example, you may pay a 7% surrender fee the first year, but a 6% surrender fee the second year, and so on, until you are past the surrender period.

Many annuities will allow you to withdraw part of your account value each year without a surrender fee, but make sure you know what to expect before initiating a withdrawal.

While many insurers will describe annuities as the income stream you can't outlive, the truth is that they aren't suitable for everyone. Some annuities cost upward of 2% annually, and if you add riders for services, you could be paying even more. The fees may not be worthwhile compared to a mutual fund or other retirement accounts.

Before discussing potential annuities with brokers, do your research and develop a list of questions to ask. Don't be shy about asking for detailed answers and consulting a retirement planner or tax professional for assistance. Annuities may be a helpful tool to have some extra money in retirement, but only if you go in with your eyes wide open.