An annuity can be an important retirement planning tool that provides guaranteed income when you're no longer working—and those income payments could last the rest of your life. Some annuities will even invest your premiums and allow your money to grow tax-deferred. This is all to say that knowing how to buy an annuity can come in handy. Here's a closer look at how it works and what you need to know before buying an annuity.
What Is an Annuity?
An annuity is a contract you establish with an insurer that can provide regular cash disbursements when you retire. Annuities are considered safe investments that could help round out your financial portfolio and pad your nest egg.
Learn more >> Are Annuities Safe?
Using Annuities for Retirement
Annuities can play a powerful role in retirement planning. You might piece together retirement income from a combination of annuities and:
- 401(k)s, individual retirement accounts (IRAs) and other retirement accounts
- Pensions
- Social Security benefits
- Cash value accruing in a permanent life insurance policy
- Real estate investments and other passive income streams
Learn more >> Annuity vs. IRA: Which Is Better for Retirement?
5 Steps to Buy an Annuity
Below is a step-by-step guide for buying an annuity. Knowing what to expect can help you get the most out of this low-risk investment.
1. Decide Which Type of Annuity Is Best For Your Goals
There are several different kinds of annuities, but they generally fall into one of the following categories:
- Fixed annuities: These provide guaranteed, fixed income payments in retirement.
- Variable annuities: Your premiums can be invested, which means that your earnings will depend on how those investments perform. After a certain point, you'll start receiving recurring minimum payments.
- Indexed annuities: These annuities offer two returns—one that's fixed and another that's linked to a stock market index.
If you're looking for a safe investment that offers predictable, steady returns, a fixed annuity might make the most sense. Just keep in mind that these payments could diminish in value over time, thanks to inflation.
Those who are comfortable assuming more risk might go with a variable or indexed annuity, which allows you to invest in stocks, bonds, mutual funds and money market funds. That could lead to greater returns in the long run, though gains are never guaranteed.
Either way, you can choose between:
- Immediate annuity: Payments begin soon after purchasing the annuity.
- Deferred annuity. Payments kick in at a specified time in the future.
Learn more >> Types of Annuities to Know
2. Research Annuity Providers
Annuities are offered by insurers, banks, brokerage firms and mutual fund companies. It's best to shop around and compare annuities from different providers. Pay attention to:
- The company's fee structure
- Returns and how much you can expect to receive when your income payments begin
- Whether the annuity has a death benefit provision, which would allow a beneficiary to receive a portion of your benefit after you're gone
- Fees you may incur for closing the annuity early
- Online reviews to gauge the company's customer service and dependability
3. Open Your Annuity
You'll likely need to provide basic financial information to apply for an annuity. Be sure to read the contract carefully, keeping an eye out for fees and stipulations that could cost you money down the road. For example, some providers charge a surrender fee if you cancel an annuity or cash it out early. This can range anywhere from 5% to 25% of the amount withdrawn. A financial advisor can help you review the contract to ensure the annuity aligns with your financial goals.
4. Fund Your Annuity
You might cover your premium with a single lump-sum payment or multiple payments. Making the purchase with a checking, savings or Roth account can help you avoid unwanted tax penalties. When you pull money from a tax-deferred account, like a 401(k) or traditional IRA, you'll pay taxes on the withdrawal. You'll also face a 10% early withdrawal penalty if you're younger than 59½.
5. Understand the Free-Look Period
Your annuity contract should include information about a free-look period. During this time, which typically lasts anywhere from 10 to 30 days after purchasing an annuity, you can cancel your contract and receive a full refund—without incurring a surrender penalty. If you have questions about your annuity, reach out to your provider for clarification.
Benefits of Annuities
Here are the main financial benefits of buying an annuity:
- They can help you save for retirement. Annuities can provide steady income payments when you're no longer working.
- Annuities might help diversify your financial portfolio. Diversification can help mitigate overall investment risk.
- Annuities carry little risk. Annuities are insured by state guaranty associations. Most states cover at least $250,000 per customer, per company.
- Some annuities offer a death benefit. That can provide a beneficiary with peace of mind and financial support.
How Much Does It Cost to Buy an Annuity?
Your total annuity costs will depend on the following factors.
Your Premium
This is the amount you pay to purchase an annuity. You have flexibility here and can decide how much to put in. The payout you receive in the future will depend on your paid premiums, as well as any interest earned, minus fees.
Fees
Annuities have annual fees, which can add up to 3% or more per year. These fees typically include:
- Administrative fees
- Surrender fees for canceling an annuity or cashing it out early
- Mortality fees for providing a death benefit
- Mutual fund fees (if your annuity premiums are invested in mutual funds)
- Costs for adding extra riders to your annuity, like a rider that provides guaranteed payments if you lose income due to a disability
When Is the Best Time to Buy an Annuity?
When it comes to buying an annuity, there isn't one right or wrong time to make the investment. Your timeline will depend on whether:
- You want to receive income payments in retirement. If you're approaching retirement and are concerned about outliving your money, purchasing a fixed annuity can provide peace of mind. And you can receive your payments immediately or at a later time.
- You're looking to build steady, long-term gains. If you have a long time horizon and your goal is to invest in a low-risk, tax-deferred way, an annuity might be a nice addition to your portfolio.
Learn more >> Are Annuities a Good Investment?
The Bottom Line
If you're curious about how to buy an annuity, begin with your investment goals and why you're seeking an annuity in the first place. That can help guide you toward the right type of annuity for your needs. From there, you can compare providers before opening and funding your annuity. Just be sure to consider how an annuity supports your overarching retirement income plan.