You can use an annuity to create a predictable and long-lasting income stream for your retirement years. However, the marketplace for guaranteed-income investments is crowded. Annuity issuers face competition from banks issuing certificates of deposit and public and private sector entities issuing bonds. With so many options available, it is important you understand the differences between annuities and other income-generating investments.
Annuity contracts are life insurance policies that protect you against financial hardship caused by your own longevity. You can purchase an annuity with a single premium or you can make a series of purchase payments over the course of many years. An immediate annuity provides you with an income stream that begins without delay. A deferred annuity is a contract within which your premiums are invested for a number of years before being converted into a monthly income stream. You can buy individual annuities or joint contracts. You also have the option of buying a contract that provides lifetime income or a policy that generates income payments for a fixed period of time.
Some annuities protect your principal, meaning the value of your contract can never drop below your original premium payments. Other annuities offer no principal guarantees but assure you of fixed monthly income payments regardless of the value of the actual contract. You could lose money if your insurer goes bust. State guaranty funds cover some of your losses if your insurer becomes insolvent, although protection guarantees vary from state to state. Bank certificates of deposit are principal-protected, and the Federal Deposit Insurance Corporation insures your deposits for up to $250,000 per account, per bank. The FDIC does not guarantee bonds, although Treasury bonds are backed by the full faith of the federal government. In theory, you could lose your whole investment if a bond issuer goes out of business.
Investment professionals regard the federal government as the least-risky borrower. Consequently, yields on federal bonds are generally lower than yields available on annuities and some longer-term bank CDs. In contrast, bonds tied to volatile assets such as mortgages often pay higher yields than annuities. Generally speaking, your potential returns are higher if you expose your investment to greater levels of risk. Other factors, such as your age, can also impact the rate you earn on an annuity. In contrast, two people owning the same CD or bond earn the same rate of return regardless of their life expectancy.
You can hold a CD within a tax-deferred investment, such as an individual retirement account. Ordinarily, though, a basic bank CD provides you with no tax benefits. Likewise, you can get tax perks by housing bonds in retirement accounts, although some types of municipal bonds generate tax-free income regardless of where the bonds are housed. Annuities grow on a tax-deferred basis. You do not pay any taxes on your earnings until you make withdrawals. You also have the option of funding an annuity with pre-tax money, in which case you can enjoy even more tax-deferred earnings. On the downside, you typically must pay ordinary income tax and a 10 percent federal tax penalty on any previously untaxed funds if you make withdrawals before reaching the age of 59 1/2.
Some annuity firms raise your guaranteed income or offer your beneficiaries various payout guarantees if you agree to pay charges known as riders. Generally, these charges are deducted either from your original premium or from your regular withdrawals. In many instances, you also pay hefty surrender penalties if you decide to forgo the income payments and cash in the contract. Similar penalties apply when you cash in a CD, although you do not typically pay any other fees for CDs. You may pay a broker's fee when you buy a bond and a further fee if you sell your bond before it matures. You may lose a chunk of your investment or make extra cash if you sell your bond mid-term for at a discount or for a premium.