If retirement legislation currently under consideration in Congress ends up becoming law, new options for your nest egg may show up in your 401(k) plan.
The Secure Act, which passed the House in May and awaits Senate action, includes a provision that would make it easier for companies to include annuities in their retirement plans. And while people may be drawn to these guaranteed-income options, it’s important to grasp both the pros and cons before putting any money into one.
“As with any investment, It’s important to understand how it works, what it costs and how it fits into your overall financial plan,” said Frank O’Connor, vice president of research for the Insured Retirement Institute.
In simple terms, annuities can provide a way for retirees to ensure they receive lifetime income from their savings.
While companies already can offer annuities in their 401(k) lineups, just 9% do, according to the Plan Sponsor Council of America. The Secure Act aims to eliminate companies’ fear of legal liability if the annuity provider fails or otherwise fails to deliver.
Although an annuity might include an investment component, it’s a contract: You hand over your money — either all at once or through regular contributions — and the provider (typically an insurance company) promises to provide regular payments to you across many years. Sometimes, that can be decades.
A man reaching age 65 can expect to live, on average, until age 84, according to the Social Security Administration. For a woman, the average is 86.5. About a third of all 65-year-olds today will live past age 90, with about one in seven living beyond age 95.
For people who worry about outliving their assets, an annuity can help ensure that their savings will last their lifetime. Yet there are a variety of packages, which can be tricky to understand and often are more expensive than other choices for where to keep your money.
“An annuity serves as guardrails for your principal at the same time it provides guaranteed life income,” O’Connor said. “But, it comes with a cost.
“There are fees that options without an income guarantee don’t have.”
Nevertheless, annuities can make sense for some people.
“If someone decides to get an annuity, they’re doing it because they either need guaranteed income for life or they need peace of mind,” said certified financial planner Malik Lee, managing principal of Felton & Peel Wealth Management in Atlanta. “But you should want a fiduciary on your side to help you navigate them.”
Although annuities can vary widely — both in terms of cost and particular guarantees — there are some broad commonalities.
For instance, once you hand your money over to the insurer offering the annuity, it can be costly to change your mind after a short initial review period.
Depending on the contract, you could pay what’s called a surrender charge after that window if you no longer want the annuity or withdraw more from it than allowed. That fee can be pretty steep, especially in the early years of the contract.
By way of example: An eight-year surrender period might come with an 8% charge in the first year that gradually decreases before reaching 1% in year eight.
Also, it’s important to know that if you take money out of an annuity before age 59½, you’ll pay a 10% tax penalty, just like with early withdrawals from 401(k) plans and traditional individual retirement accounts.
Otherwise, the annuity payments made to you are taxed as regular income (including the interest earned), assuming you haven’t yet paid any taxes on the money you used to purchase the contract. If you use after-tax money, only the interest or earnings portion of your payment is taxed.
Annuities can be immediate, which involves starting the income stream right away. Others are deferred, in which case at some future date you can annuitize — meaning you agree to receive a periodic amount — for a set time period or for the rest of your life.
Both immediate and deferred annuities can be fixed or variable. A fixed annuity gives you a guaranteed rate of return on your principal.