As financial tools go, fixed annuities are not particularly flashy. In exchange for a premium or a lump sum of cash, these insurance contracts earn a moderate fixed return, currently 1.5% to 3% a year, to deliver a steady, guaranteed income for the rest of your life and even that of a spouse or partner. "It's like having your own personal pension plan," says Sara Wiener, assistant vice president of annuities at Principal Financial Group in Des Moines, Iowa.
You can set up an immediate annuity with a lump sum deposit to collect income right away or pay a series of premiums, either monthly or annually, for a deferred annuity, which starts paying you at a future date. Once you begin drawing the income, you stop paying premiums.
Although some contracts can be set up for as little as $5,000, the more you pay into your fixed annuity, the higher your monthly income will be. For example, a 65-year-old man who buys a $250,000 fixed immediate annuity can get $1,252 a month for the rest of his life, according to Charles Schwab's fixed annuity calculator (opens in new tab). To generate the same guaranteed lifetime income with a deferred annuity, a 55-year-old planning to retire in 10 years will need to contribute about $1,800 a month for a decade.
Annuities haven't always had the best reputation -- and with good reason. The fees and commissions an annuity issuer charges can be high. Once you turn over a lump sum, you lose control over the money. If you change your mind or need to tap the funds early, you'll pay a surrender charge, typically about 7% of the withdrawal amount, which declines about 1% a year before disappearing altogether. Because of their complexity and cost, annuities often require careful research and impartial advice from a financial professional who doesn't have a stake in selling you a contract.
Compared with indexed and variable annuities, which are more complex and potentially expensive, fixed annuities are simpler, pay a predictable return and generally have lower costs. They're also surprisingly versatile with uses that go beyond generating reliable retirement income. "Annuities today are much more consumer-friendly and multipurpose than in years past," Wiener says.
Depending on the setup, annuities can be used to pay for long-term care, simplify estate planning or help retirees manage their money better. Some fixed annuities are designed for a specific purpose, such as donating to charity, while others can be used to reduce required minimum distributions from a traditional retirement savings account.
Use the Bucket Strategy for Your Annuities
Because the payments from a fixed annuity don't fluctuate with the stock market, retirees always know how much money they have to live on. That's particularly important in the early years when many retirees would like to spend more because they can do more.
To stay on budget, you could divide your money across multiple annuity contracts using a bucket strategy that allocates funds for short-term, intermediate and long-term expenses. For example, if you've just retired, one of the contracts could be set up to start payments now, another in five years when your spouse plans to retire and a third in 10 years when you expect higher health care bills. You'll receive some money for your current needs while the deferred annuities keep growing to offer higher payments later.
Try A Bond Market Hedge
Lifetime payments are not your only option. You can structure annuity payments for a set number of years, which opens up other strategies, particularly with investing. As a short-term investment, annuities are a good alternative to bonds, certificates of deposit and other fixed-income assets, says Michael Foguth, founder of Foguth Financial Group in Brighton, Mich.
Bank accounts and CDs currently pay next to nothing. Although bonds may pay more, they also carry more risk when interest rates rise and bond prices fall. Foguth recently asked a client who was invested in 20-year bonds, "Do you think rates will go up sometime in the next 20 years?" It was a rhetorical question. "Of course they will, and when they do, these bonds are going to get hammered," Foguth told his client.
When interest rates rise, someone holding long-term bonds can either keep the bonds that pay a below market rate or sell them at a loss to buy new ones paying more interest. Foguth says fixed annuities are a better deal. "They pay significantly more than the bank or CDs but don't have the bond interest rate risk." If rates rise, you'll continue earning the same income and will get your deposit back by the end of the contract. For a bond market hedge, Foguth advises setting up a fixed immediate annuity to pay out over two to three years. That way, if rates rise, you'll have your money back to take advantage of the higher interest.
Transfer Wealth to Your Heirs
An annuity also lets you transfer wealth to others. There are a few ways to do this. An annuity with a death benefit directs the remaining value of your contract to a beneficiary in a lump sum or a series of payments. You could also get a joint life annuity policy. Most people do this with a spouse, but you could pick anyone, including your child. The payments come to you first and then continue for your survivor.
Keep in mind that any of these inheritance strategies will reduce the monthly income the annuity pays you. For example, a 75-year-old woman who buys a fixed annuity for $300,000 will receive $1,960 per month if the payments last only for her life. If she sets up a $300,000 life annuity with 20 years of guaranteed payments, she will collect $1,538 per month, and if she dies within 20 years, her heirs get the remaining payments. A joint life contract with her 50-year-old son pays $1,142 per month as long as either of them is alive.
Annuities offer two advantages for transferring wealth, says John Williams, regional sales director of individual annuities at The Standard, an annuity provider. One is that it can rein in a spendthrift heir. A mother who is worried about an adult child's spending "can set up the annuity death benefit to be paid over time, like 10 years of moderate payments, rather than a large lump sum all at once." The other advantage is that it spreads out the tax impact of the inheritance for your heirs, who only pay income tax on the annuity payments when they receive them. Although the annuity bypasses probate so that a named beneficiary inherits the contract immediately, its value at the time of the annuitant's death still counts as part of the estate and is subject to estate taxes.
Delay Taking Your Social Security Benefits
If you haven't started taking Social Security, Wiener suggests buying a fixed annuity to cover your bills so you can delay claiming benefits. Although you can start collecting Social Security at age 62, the monthly amount increases every year you wait until age 70, when you must begin taking benefits.
The difference can be significant. In an example from Social Security, a $708-per-month benefit for someone who starts taking it at age 62 becomes $1,013 at age 67 and $1,253 at age 70. Those higher benefits last your entire life and even continue for a lower-earning surviving spouse, who potentially could swap a smaller benefit for your larger one after you're gone.
There are drawbacks to using an annuity this way. "If you die early in your retirement, there's no bucket of Social Security funds that you can give to others" besides a spouse, says Wiener. In exchange for the higher benefit, you've spent down assets that could have been left to heirs. The strategy is best for retirees in good health who want more reliable income.
Buy Coverage for Long-Term Care
To help cover long-term care expenses, consider buying an annuity with a long-term care rider. A portion of the funds is set aside for your care with your heirs getting any unspent money. Under the Pension Protection Act, the long-term care payments are tax-free, says Martin Powell, head of annuity distribution at CUNA Mutual Group, adding, "this includes any investment gains from the annuity itself."
Another advantage is that the underwriting for annuities with long-term care coverage is easier. "For people with some health care issues, they might not be able to qualify for a standalone insurance policy, but they may qualify for this type of annuity," says Powell.
If you are in good health and want more coverage, Powell suggests getting a standalone long-term care insurance policy and using payments from a regular annuity to cover the premiums. "Pure long-term care insurance typically has a higher benefit," he says.
Qualify for Medicaid Faster
If you require a nursing home, you'll need to deplete most of your assets to qualify for Medicaid, but that can leave your spouse with little to live on. Although requirements vary by state, generally you must spend down nearly all of your assets to less than $2,000 with exceptions for some things like your personal residence and one vehicle.
You can keep more of your savings if you buy a Medicaid-compliant annuity, which pays you and a spouse income for life and does not count toward the Medicaid asset test, letting you qualify faster. For the annuity to be Medicaid-compliant, the payments must start immediately, with the state named as the beneficiary. The state gets any remaining payments after you and your spouse are gone.
Give Money to Charity
If you want to leave a large donation to charity while generating some retirement income for yourself, a charitable gift annuity lets you do both and take a sizable upfront tax deduction. Instead of writing a check, a donor who wants to give $250,000 to charity could buy a charitable gift annuity for the same amount. The annuity pays a lifetime of payments to the donor and one other beneficiary, like a spouse, with the money going to the donor first.
The donor also gets a partial deduction for the $250,000 contribution the year the annuity is set up. Only a portion is deductible because the IRS considers the rest an investment to generate future income. The annuity provider calculates the total deduction based on the donor's age, any beneficiary, and the amount of expected annuity payments. After the donor and beneficiary pass away, the charity receives the remaining annuity value.
Foguth sees a few scenarios when this strategy makes sense. "A client might do this when they have a larger taxable year than normal, like their business was just bought out or they sold a rental property," he says. "A charitable gift annuity can help balance out these considerable tax hits." Some people, he says, use this strategy to give to charity and minimize estate taxes because the money used for the charitable gift annuity is not part of the taxable estate.
He warns that once you purchase the charitable gift annuity, the money is gone as these contracts are irreversible. Also, the income payments are smaller than an ordinary fixed annuity's. The strategy is meant for large donations, Foguth says. "You typically don't see this with $5,000, $10,000 donations. It's more common with large five- or six-figure donations."
Still, if you have the assets to spare and want to support a charity, this is an effective way to do it. "Not only do they make the initial donation by buying the charitable gift annuity, they could also double down by donating any income they don't need from the contract," says Foguth.
Reduce Your RMDs
At first, using the savings in an IRA or 401(k) to buy an annuity held in the retirement account sounds like a waste of time. There's a perception that people should not do this, says Williams. For one thing, taxes on the annuity's gains are delayed until the money is taken out, but you already have that advantage in an IRA or 401(k). For another, money withdrawn from the retirement account, whether from an annuity or other investments, is taxed the same -- as ordinary income.
Typically, a fixed annuity inside a retirement account won't reduce required minimum distributions, either. Once you turn 72 (or 70½ before 2020), you still must take those RMDs, with the amount based on the account's total value, annuity included. You can meet this obligation by collecting fixed annuity payments as well as by cashing out other investments. If you need to take out more than the scheduled annuity payments to satisfy the RMD, some insurers will waive any surrender charges for tapping the money early.
But if you are concerned about RMDs forcing you to make taxable withdrawals you don't need, you could transfer part of your retirement account balance into a qualified life annuity contract. The amount transferred into the deferred annuity no longer counts for the RMD formula, and the income, which doubles as your distributions, can be delayed until age 85. You reduce your RMDs now while creating future lifetime income.
Using retirement funds to buy an annuity has other advantages, too. By keeping it inside the IRA, you don't have to make a taxable withdrawal to buy the annuity, so you keep deferring your taxable gains until you receive the annuity payments.
Whichever way you choose to use an annuity, shop around. Annuity companies offer different rates and benefits on their contracts, so finding better terms could make a big difference, especially for a large, lifetime purchase.
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