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Just like with most other investment options, it’s essential to realize what you are purchasing before you sign your name on the dotted line. This is one of the few reasons why so many individuals shy away from annuities; they can be somewhat complicated. However merely because annuities can be complex, it doesn’t necessarily suggest you should always count them out. In fact, for most individuals, they represent a safe and effective method to save for retirement. Here is a glance at five of the most important rules for annuities, according to most financial advisors.

Rule #1: Annuities will not provide an instant tax deduction.

Conventional IRAs and 401(k)s are so appealing because you enjoy an up-front tax deduction for contributing to them. With a 401(k), you deposit directly from your payroll check, pre-tax, however, with an IRA, you fund your account and then get to subtract that money on your income tax return.

Annuities are different. When annuities are paid for outside of an IRA, they are funded with after-tax money (no tax-break there). But the funds in your annuity are allowed to grow on a tax-deferred basis; therefore you will not pay taxes on any gains until you finally start taking withdrawals.

Rule #2: Annuities have early withdrawal penalties, just like traditional retirement accounts.

One of the most important rules for annuities is their absence of liquidity. Then again the function of an annuity is to offer a stream of income during retirement, so it’s easy to understand why you can’t simply cash out anytime you want to. Additionally, you will face early withdrawal penalties if you prematurely withdraw funds from traditional retirement accounts also. That’s just how it works.

Similar to other product rules, there are some exceptions. If you happen to become completely disabled, or even worse, pass away, you might be able to obtain your funds early, without paying the penalty. However, it’s recommended to abstain from touching your annuity before attaining age 59 ½. Not only will you need to pay a substantial penalty, but that money will not be there for you when you need it the most.

Rule #3: Canceling your annuity will cost you money.

Consider your annuity contract like a contract on a rental. When you sign a lease, you agree to pay the rent for the stipulated amount of time. If you break the lease early, you are still accountable for the remaining term of the lease.

The very same holds true for an annuity. If you cancel the annuity contract, you could possibly face significant surrender charges, based on the sum you ultimately take out. Surrender fees generally start at about 7% during the first year of the contract and then decrease 1% each year.

Once again, just like with premature withdrawals, there are a few exceptions to this rule. You can typically withdraw up to 10% of your annuity’s economic value each year without any surrender charge. Furthermore, if you end up terminally ill or disabled, or if you die, the surrender charge for getting the funds early is usually waived. Ultimately, if you end up with buyer’s remorse and change your mind regarding your annuity early on, you typically have a 30 day period to surrender your annuity without being charged.

Rule #4: Annuity withdrawals are usually partially taxable.

Similar to the money you withdraw from a conventional IRA or 401(k), your annuity withdrawals are also subject to income taxes. The manner in which they are taxed is a touch unusual, however. If you simply take funds out on your own timetable, annuities are taxed on a last-in, first-out basis. That means that when you take your distributions, they are originally considered to have paid from the earnings part of your account, so they will be taxed.

However, once the actual value of your annuity drops below the amount you earned in interest, your withdrawals will no longer be taxable because they are considered a return of premiums.  If you convert the annuity to a stream of payments, then the part of each payment that represents earnings will be taxed, while the part representing your original premium payment will be tax-free. This is another of the important rules for annuities.

Rule #5: There is no annual contribution limit.

Unlike various other tax-deferred retirement plans like 401(k)s and IRAs, there is no annual contribution limit for your annuity. This allows you to store away a lot more money for retirement and is especially useful for those individuals who are closest to their retirement age and want to catch up.

The money that you invest in your annuity compounds yearly without having any tax liability from the IRS. This ability to maintain every dollar invested working for you will be a huge advantage over other taxable investments.

When you finally cash out, you can elect to receive a lump-sum payment, but most retirees opt to set up guaranteed payments for a specified length of time or for the rest of their life, delivering a regular stream of income. Your annuity functions as a supplement to other retirement income resources, such as Social Security and pension plans.

Annuities are certainly not for everybody, but for those individuals who are looking to lock in guaranteed income for life, it’s a solution worth considering. Learning about annuity products is the first step, and as always, speaking to your trusted financial advisor is always encouraged.

For in-depth information on the basics of annuities, we recommend that you review Annuity Basics, which provides straight forward information about annuities and how they can become a valuable tool in your retirement planning toolbox.

For more information about annuities and how they can be a great vehicle for funding your retirement plan, call the financial advisors at The Lunsford Agency at (740) 779-0246 during normal business hours, or you can contact us at your convenience through our website.