Purchasing an annuity can provide you with an additional stream of income for retirement. One thing you’ll have to decide is to annuitize payments or opt for lifetime withdrawals. Whether it makes sense to opt for annuitization vs. withdrawal can depend on how long you expect to need income from the annuity, your retirement budget and your life expectancy. Here’s what you have to consider.
A financial advisor can help you create a financial plan for your retirement needs and goals.
How Does an Annuity Work?
An annuity is a type of insurance contract, though it doesn’t work the same as life insurance. When you buy a life insurance policy, the policy pays out a death benefit to your beneficiaries once you pass away. Annuities, on the other hand, provide you with income during your lifetime.
There are different types of annuities, including immediate or deferred. With immediate annuities, payments typically begin within 12 months of paying the premiums. Deferred annuities schedule payments to begin at some future date. For instance, you might buy an annuity when you’re 55 but not begin receiving payments for another 10 years.
When purchasing an annuity, there are some key things you’ll need to decide, including:
- What type of annuity to buy
- How long the payments should last
- Who should be listed as your annuity beneficiary
You’ll also need to tell the insurance company whether you’d like annuitized payouts or lifetime withdrawals.
What Is Annuitization?
Annuitization is the process by which your annuity is converted into regular income payments. When you annuitize payments, the insurance company agrees to pay money to you on a fixed schedule. You might receive those payments for a set number of years or for the rest of your natural life.
The amount you receive from annuitized payments can depend on how much you paid in premiums to purchase the contract, your life expectancy and the annuity’s rate of growth. Once you annuitize, you’re no longer able to tap into the contract’s principal value since payments are not permanent.
When you receive annuitized payments, part of it is considered to be a return of principal to you. That applies until all of the original premiums you paid in have come back to you. Any leftover payment amounts are classified as taxable income.
Annuitized payments can continue until you pass away, at which time any remaining cash value in the policy can be paid out as a death benefit to your beneficiary. You may also structure an annuity to continue making payments to your spouse after you’re gone. In that case, your spouse could name their own beneficiary to receive a death benefit from the contract.
What Are Lifetime Withdrawals?
Lifetime withdrawals are another way to receive money from an annuity contract. If you opt for lifetime withdrawals, you can take out a certain amount of money each year. You don’t have to annuitize payments or sacrifice any of the remaining cash value in the contract.
The amount you can receive is typically determined as a percentage of the annuity contract’s principal or its cash value. You can withdraw up to the yearly amount and you have the option to start or stop payments as needed.
Your annuity company might charge a fee for lifetime withdrawal benefits. This fee may be assessed yearly. Any withdrawals you make will reduce the cash value of the contract.
Annuitization vs. Withdrawals: Key Differences
Annuitized payments and lifetime withdrawals both offer an avenue for tapping into your annuity income. But they aren’t identical in terms of the pros and cons or how they work overall.
Here are five key differences to consider when comparing annuitization vs. withdrawals:
- Payout amounts. Annuitizing can potentially result in higher payouts, depending on how long you’re scheduled to receive income from the contract. Lifetime withdrawals may result in lower payouts depending on how the payment calculation formula is applied.
- Flexibility. Once you annuitize payments, you can’t change your mind. You’re committed to receiving those payments at that point. Opting for lifetime withdrawals, on the other hand, allows you some flexibility since you’re not obligated to withdraw the full amount allowed each year.
- Fees. Annuities can come with lots of fees but there’s typically no extra cost to annuitize your payments. You may, however, pay a yearly charge to receive lifetime withdrawals instead.
- Cash value. When you annuitize payments, you no longer have access to any cash value in the contract. Should you choose lifetime withdrawals instead, you’d still have access to the cash value, and it could continue earning interest.
- Death benefit. Annuitization may not allow for a death benefit to be paid to your beneficiaries once you pass away. With lifetime withdrawals, beneficiaries may be able to receive a death benefit from any remaining cash value in the contract.
Annuitization vs. Withdrawals: Which One Is Better?
Whether you’re better off with annuitized payments or taking advantage of lifetime withdrawals can depend on your financial situation. Annuitizing gives you the benefit of guaranteed income for life. That may appeal to you if you’d like to have some certainty about how much money you’ll have to cover your expenses in retirement.
Lifetime withdrawals, on the other hand, allow for more flexibility since you can start or stop payments and you don’t necessarily have to withdraw the full amount allowed by the contract each year. You might appreciate that more if you have other assets or sources of income to rely on for retirement and you don’t want to be locked in to an annuitized contract.
Annuities can provide a sense of financial security for retirement since you’ll have a ready source of income to tap into. Understanding what it means to annuitize payments vs. opting for lifetime withdrawals can help you decide which one makes the most sense.
Retirement Planning Tips
- Consider talking to your financial advisor about the different types of annuities available and which one, if any, could be a good fit for your needs. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When considering an annuity for retirement, remember to weigh the fees and the potential tax implications. In addition to lifetime withdrawal fees, annuities can carry a number of other costs, all of which add to the overall expense of owning them. Depending on how you fund your annuity, either with pre-tax or after-tax dollars, you may have to pay ordinary income tax on withdrawals later. If you’re receiving annuity payments while also making taxable withdrawals from a 401(k) or IRA, it’s important to know what that might mean for your overall tax liability.
- Remember that annuities are not the only way to save and plan for retirement. Contributing to a 401(k) or IRA can help you grow wealth on a tax-advantaged basis. You can open a traditional or Roth IRA through an online brokerage, along with a taxable investment account for additional savings.
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Rebecca Lake, CEPF® Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.