I am always happy to answer reader questions. And I got a doozy recently:
Which is better: fixed or variable annuity?
As always, what is better for you depends on your individual personal finance goals and situation. However, by explaining the differences, you can perhaps get an idea of what might work better for you.
First of all, an annuity is an investment that pays out regularly, based on what you have put in. In the case of annuities related to retirement, you receive a regular payout starting at 59 1/2. There are also life annuities that guaranty a certain amount of money for a person’s lifetime, starting at a certain age. In an annuity, your investment grows and is then distributed back to you. Annuities are generally tax-deferred.
A fixed annuity is a contract from an insurance company that promises to pay a fixed rate of interest. It’s a lot like the CD you take out at the bank. The interest earned, though, is tax-deferred, meaning you don’t have to pay on it until you withdraw. (Penalties apply before age 59 1/2.) Your fixed annuity earnings are charged as income when you do begin to withdraw them. A fixed annuity, since it guarantees a certain rate of return, carries a lower risk of loss, but limits the chances of growth.
Instead of relying on a promised rate of return, a variable annuity provides returns based on the values of underlying investments. It’s sort of like a mutual fund. There are subaccounts that you invest in, whether they are stocks or bonds (or both). A variable annuity comes with its own fees and expenses, which are usually higher than those associated with a fixed annuity. Your variable annuity is tax-deferred, and the gains are taxed at the normal income tax rate when you withdraw. This can be a bit of a setback, since you might have gains that could be properly seen as long term capital gains with a much lower tax requirement. However, in the annuity, they are taxed at the higher personal income rate. The return has a potential to be higher with the variable annuity than with the fixed annuity, but you are taking on risk.
An annuity can be very helpful, but you have to be careful. If you are risk averse, then a fixed annuity is probably the better choice — and it can even be a good part of an investment portfolio that needs a little more safety. If you have the risk tolerance for it, and want the possibility of higher returns, a variable annuity might be helpful.
In the end, while annuities can be interesting investment vehicles, it is important to fully understand how they work. You might actually be better off looking into other types of investment. There is no reason to take retirement fund money and put it into an annuity, for example. A retirement account, such as an IRA or 401k, already has tax advantages. Additionally, there are other investments, such as index funds, ETFs and low-cost mutual funds, that provide you with the possibility of returns while providing you the ability to take advantage of the lower tax rates associated with long term capital gains.