6 Questions to Ask Before Buying an Annuity

Annuities can help you create a retirement income stream, but they may contain liabilities that can undermine your financial stability in the long run. Be mindful of things like the fees that can erode your investment, the payout rates, and the trustworthiness of the issuing company. These all play a role in whether an annuity meets your retirement needs. Here are six questions you should ask before you buy an annuity. If you prefer a hands-on approach, a financial advisor can help you evaluate annuity terms and how they fit into your broader retirement plan.

1. What Fees Will You Pay?

An annuity is an agreement where an individual either contributes a lump sum or makes a series of payments to an insurance company, in return for regular distributions that may begin immediately or at a future date. The potential benefit of an annuity is this prospect of financial security. But the associated costs can be substantial and it’s advisable for investors to carefully consider the fees. Here’s a breakdown of fee types to consider:

Administrative fees: For account management and documentation.
Mortality and expense risk charges: To cover the insurer’s risk of guaranteeing lifetime income.
Surrender charges: Applied when funds are withdrawn early, decreasing over time.

Make sure you fully understand what fees you’ll pay throughout the life of your annuity before signing on the dotted line.

2. What Is the Payout Rate?

The payout rate indicates the return on investment for the annuitant, the person receiving the income. It tells you how much the annuity pays as a percentage of your initial investment, or principal. To put it simply, the payout rate is calculated by dividing the annual payment by the principal and then multiplying by 100 to get a percentage. For example, if you receive $4,000 a year from a $100,000 annuity, your payout rate is 4%.

However, this rate isn’t set in stone. It varies based on several factors, including the type of annuity you choose, your age at the time of purchase, the length of the payment period, and current interest rates. Understanding these variables will help you determine whether an annuity can meet your financial goals.

3. How Trustworthy is the Insurance Company?

A company with a long-standing and stable market presence often earns a reputation for dependability and can give you peace of mind about your long-term sustainability. Some things to figure out is how long the company has been in business, whether it has had any issues paying clients in the past, and what professional ratings the company has had throughout its history.

Financial stability can be measured by ratings from respected agencies like A.M. Best, Standard & Poor’s, Moody’s, and Fitch. These ratings provide a snapshot of an insurer’s ability to meet its financial commitments. For instance, ratings range from ‘AAA’ (the highest) to ‘D’ for Standard & Poor’s and Fitch, ‘Aaa’ to ‘C’ for Moody’s, and ‘A++’ to ‘D’ for A.M. Best. A ‘AAA’ or ‘A++’ rating suggests a strong financial foundation and a high likelihood of honoring commitments. On the other hand, lower ratings might indicate potential risks.

4. Does the Annuity Offer Death Benefits?

A couple considering different factors before buying an annuity.

One of the key features that potential annuity buyers must consider is the availability of death benefits. These benefits are provisions within an annuity contract that ensure a payment is made to a designated beneficiary after the death of the annuity holder. Understanding what death benefits are and their importance is important for individuals seeking to secure their own financial future and protect beneficiaries after their death.

You should also note that these benefits can affect the pricing of annuity products, as insurers may charge additional fees for the enhanced protection they provide.

5. How Do I Get My Questions Answered After Buying?

After purchasing an annuity, you can typically get your questions answered by contacting the annuity provider’s customer service department or your financial advisor. You can confirm how to get your questions answered by reviewing the terms and conditions provided by the annuity provider, consulting any documentation received upon purchase, or directly contacting the customer service department of the annuity provider for clarification. Knowing who to turn to at the insurance company is important if you don’t have a financial advisor or in the event that you and your advisor don’t work out down the road.

6. What Taxes Could I Pay on My Annuity?

You may have to pay taxes on the earnings that you get from annuity payouts. The tax rate applied is contingent upon your income tax bracket and is exclusively attributed to the interest or earnings part of the withdrawal, sparing the principal. Take note: If the annuity is held within a tax-advantaged retirement account it is considered qualified and the entire withdrawal is taxable. To ensure you’re prepared, here’s a checklist of key tax considerations for annuity holders:

Understand the tax treatment of qualified versus non-qualified annuities.
Recognize that income tax applies only to the earnings portion of non-qualified annuities.
Be aware that distributions from qualified annuities are fully taxable as ordinary income.
Additionally, annuities can be subject to estate tax if they are incorporated into the annuitant’s estate upon their demise.

7. What Type of Annuity Fits My Goals?

Different annuities work in different ways, so it is important to choose one that matches your needs. A fixed annuity gives steady, predictable payments but usually has lower returns. A variable annuity invests in market funds, which means more growth potential but also more risk and higher fees. An indexed annuity links your growth to a market index like the S&P 500, offering limited upside and some protection against losses.

You also need to decide when you want payments to start. Immediate annuities begin right away, while deferred annuities grow over time before income begins. Lifetime annuities pay as long as you live, while period-certain annuities pay for a set number of years. The right choice depends on whether you want safety, growth, guaranteed income or money left for heirs.

Bottom Line

A client reviewing an annuity contract with a financial advisor.

The decision to invest in an annuity requires careful consideration. You should keep in mind various factors, including fees, payout rates, insurer reliability, death benefits, post-purchase support and tax implications. Each of these plays a critical role in determining the suitability of an annuity for your retirement plan. Prospective buyers must weigh the costs and benefits, understand the financial stability of the issuing company and consider the impact of taxes on their investment.

Tips for Retirement Planning

A financial advisor can provide retirement planning expertise to help you save enough for your needs and goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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