When you think about income, what comes to mind? Generally, the word "income" may conjure up ideas of salary or hourly wages earned at work. However, there are other forms of income available to people, especially during retirement. One example is annuities.
While annuities don't necessarily offer as much cash flow as a salaried job would, fixed and variable annuities can help contribute to your overall income in your golden years. But because there are two main types of annuities, fixed annuity vs. variable annuity, it might be challenging to decide which is best for you.
Here are the features of each type of annuity as well as a thorough explanation of how they're different.
What Is an Annuity?
Before delving into the types of annuities, you might be wondering what an annuity is. An annuity is an insurance contract between a consumer and an insurance company. The goal of an annuity is to provide retirees with income, and most consumers lock in annuity contracts when they are younger.
Is an Annuity an Investment Product?
An annuity is not an investment product. An annuity is an insurance contract. When you buy an annuity, you are not buying securities like stocks or mutual funds. You agree to an insurance contract with an insurer.
That said, annuities have similar qualities to many investment accounts. The funds inside annuities can be tied to market values, which is why they're often confused with investment products.
What Is a Fixed Annuity?
A fixed annuity is an insurance contract that guarantees a set interest rate and a set payout, usually when you reach retirement age. The purchaser makes either a lump sum or regular payments to the insurer in return for this guarantee. Payments are not based on the investment performance of any underlying securities and, as such, offer little or no potential for gain. However, they also carry no risk of loss.
Customers typically purchase fixed annuities from financial institutions. Because these contracts provide guaranteed income payments for life (or for a specified number of years), they are often used as a supplemental source of retirement income.
Ultimately, fixed annuities offer predictability and stability, making them ideal for retirees who want to know exactly how much money they will be receiving each year. The amount paid out monthly, quarterly, etc., is guaranteed regardless of how well the market performs after purchasing the annuity.
Because of this, fixed annuities are considered a safe investment since they work like CDs or treasury bonds. They also provide tax-deferred growth. Customers will pay ordinary income taxes on withdrawals, which typically start at age 59 and a half. If you want to end the contract and withdraw money prior to age 59 and a half, there will be penalties and potentially additional fees, too. If you made a lump sum payment at the beginning of your annuity contract, ask your insurer or CPA whether or not that will be taxed or returned.
What Is a Variable Annuity?
A variable annuity is also a financial contract between a customer and an insurance company used to help individuals save money for retirement. With this type of contract, the investor agrees to pay either fixed annual amounts or a percentage of their income into an account on which earnings are expected to accumulate over time.
This agreement usually includes the provision that upon certain conditions (such as reaching a specific age), payments will begin from these investments and continue throughout a customer's lifetime (or a set period).
The value of the payments received under a variable annuity contract depends on the investment performance of the underlying securities. If they perform well, payments will be greater; if they perform poorly, payments will be lower. The investor bears all the risk associated with changes in market conditions and is able to choose among various investment options offered by the insurance company issuing the contract.
Customers typically purchase variable annuities through an insurance company. Payments into these contracts enjoy tax-deferred growth, but like fixed annuities, withdrawals are taxed as ordinary income. If you made a lump sum payment at the beginning of your annuity contract, it's possible that will be taxed differently. Ask your insurer or CPA if you have questions.
Comparing a Fixed Annuity vs. Variable Annuity
Fixed annuities don't fluctuate with market conditions, while variable ones change as the market changes. Fixed annuities typically have a set income rate, but with variable annuities, there isn't a guaranteed interest rate.
Fixed and variable annuities both offer an income stream in retirement; however, the two types do so in different ways. The former will always provide you with regular cash flow (minus any fees or taxes). The latter, variable annuities, might not. Because they do change along with market conditions, for better or worse, your money will fluctuate alongside the price movements in the market.
This means that if our economy is doing well and stock prices increase during retirement age, then you might end up making more cash flow than before with a variable annuity. However, if another recession strikes while you're enjoying your golden years (and, thus, causes stocks to go down), then you might not get as large of a payment from your variable annuity.
In sum, fixed annuities offer a fixed payout amount, and the money is guaranteed, so there is no investment risk. Variable annuities have a variable payout amount. With a variable annuity, the customer is subject to investment risk, but this also gives them the potential for higher returns if the underlying investments perform well.
Which Type of Annuity Is Right for You?
The answer to this question depends on your individual needs, goals and risk tolerance. If you're looking for a safe and stable investment, then a fixed annuity may be the right choice for you. If you're looking for the potential for higher returns, then a variable annuity may be a better option.
To help you further decide which is best for you, answer these questions.
Do you need regular cash flow or additional cash flow during retirement?
What income do you hope to have during your retirement years?
How much money do you already have saved up for retirement at this point in life?
Do you plan to invest more through other investment vehicles for retirement?
The answers to these questions should help you decide which type of annuity is best for your specific situation. For example, if you're someone who doesn't need regular cash flow during retirement because you have money saved already, then investing in a variable annuity might be better for you. This is because they usually come with more growth potential than their fixed counterparts.
On the other hand, if you're more conservative financially and want a set income that won't change regardless of what the stock market does, then a fixed annuity might be preferable.
At the end of the day, it all comes down to what you're most comfortable with and what will work best for your specific situation. Regardless of the type of annuity you choose, make sure you fully understand the fees involved and what's promised at retirement before signing on the dotted line.