What annuities are and how they work

Annuities can provide tax advantages

When you buy an annuity, the funds you invest grow on a tax-deferred basis, meaning you don't pay ordinary income tax on the earnings until you withdraw or convert to a stream of payments (referred to as "annuitization" in your contract). This can provide a significant tax advantage if you're in a lower tax bracket when you start to make withdrawals – such as when you're in retirement. Another tax deferral benefit: unlike most retirement accounts, annuities don't have IRS contribution limits.

Once you start taking money out of your annuity, it will be taxed as income. How much will you pay? It depends on whether you bought the annuity with pre-tax or post-tax dollars. When it's bought with pre-tax dollars, all the money you withdraw is generally taxed as income. However, if you use post-tax dollars to buy the annuity, you'll only pay taxes on the earnings, not the premiums you paid in. You should also know that there may be IRS tax penalties if you withdraw from your annuity before age 59½, unless you meet one of the exceptions to the penalty rules. Before making any decisions regarding an annuity, you should seek specific advice from an independent tax, legal, or financial professional.

Why are annuity contracts typically written by a life insurance company?

Annuities are a way to guarantee – or ensure – that you have a stream of income that keeps on paying, no matter how long you live. When you purchase an annuity designed to last the rest of your life, you're essentially transferring the risk of outliving your savings to the insurance company. Regardless of how long you live (even beyond age 100!), the insurance company takes on a legally binding responsibility to indefinitely maintain the annuity payments specified in your contract. And in fact, some people end up getting far more out of their annuity than they paid in. Life insurance companies have experience managing that kind of risk, along with the actuarial and investment expertise needed to meet long-term payment obligations.

An annuity is a contract – and you need to pay attention to the details

These are some important things to consider when reviewing the contract of an annuity.

• Annuities are not a liquid investment, which means that your money will be tied up in a contract, and each contract has different restrictions. And in most cases, you won’t be able to access money before age 59 ½ without incurring IRS penalties.

• With some annuities, you can opt to cancel or "surrender" and receive the value of your contract; however, a surrender charge may be applied if your premium (the money you paid in) was in the annuity for less than a specified number of years.

• Certain annuities may also come with annual or additional fees for optional contract features and/or optional riders.

• Some annuities or annuity benefits may be based on market performance.

• You'll also want to know what kind of financial rating your insurance company has, which indicates how financially secure the company is. You want to make sure you're purchasing from a trusted insurer, so you can feel confident the money will be there when you need it. Guardian Life Insurance Company of America continues to receive high ratings across the board.

As you're buying your annuity, make sure to ask your financial professional about the terms of any surrender charges, fees, optional features or riders and associated costs, as well as the insurance company's financial ratings.

Are annuities right for you?

An annuity can be an important part of your retirement planning strategy, along with 401(k) plans, pensions, whole life insurance cash value, and other assets. It can help you achieve a greater level of income stability, so that no matter how long you live, you won't outlive that stream of income. Every person's situation is different, but there's a simple way to determine whether to consider an annuity. First, add up all known regular expenses you'll have during retirement, then subtract other forms of guaranteed income, like a pension or Social Security. If there's a gap, then an annuity may be a smart financial option. If the income you receive from an annuity can cover your fixed costs, you can spend your other retirement savings with greater confidence.