During retirement, you may need multiple financial sources to help pay for living expenses and the cost of senior care services. Among these sources are annuities, which can be powerful tools for funding senior living. Here, we explain what an annuity is, the types you can get, how they work, what to consider about the age you start taking payments, and their benefits and drawbacks.

An older adult couple are on a walk in the woods. They hold hands and look at each other.

What is an annuity?

Annuities are one of the many options to consider when financing your retirement.  An annuity is a contract between you and an insurance company in which you make a lump sum payment or a series of payments in exchange for disbursements of money in the future.  

These disbursements can begin as soon as you stop making payments to the insurance company, or they can be deferred to a date in the future. The timing depends on how your annuity is structured.  

How does an annuity work?

Annuities work in two phases. The first phase is the accumulation phase when the value of the annuity builds through payments the individual makes. As we discussed in the previous section, the insured can either make a lump sum payment or make regular contributions.  

The second phase is the disbursement phase. This is when the insurance company makes payments to the insured on a predetermined schedule. This schedule can be structured in several ways. Some may prefer a lump sum payment, while others may prefer continuous payments for a set number of years or the rest of their lives.  

Why do people buy annuities?

People buy annuities to ensure they have a way to fund their retirement. Much like a 401(k), you can only withdraw from an annuity without penalty after age 59.5. Unfortunately, though, annuities do not come with the same tax advantages as a 401(k).  

The steady cash flow or large lump sum payment provided by annuities makes them a great way to supplement other retirement accounts. Often, people use annuities to pay for things like senior care expenses, vacations, housing, and general living costs.  

Are annuities useful for senior care expenses?

Annuities can be helpful when it comes to paying for senior care. Since they provide a dependable income stream over a predefined amount of time, annuities can be a way to pay for things like assisted living or home care.  

When using an alternative investment vehicle, like a 401(k) or IRA, you are tied to the amount of money in your account and market fluctuations. This means when we enter periods of economic downturn, you’re incentivized to withdraw as little money as possible. If not, you risk running out of funds prematurely. With an annuity, you can determine how much money you will receive each month, years before you receive it. This means you don’t have to worry about market fluctuations and can rely on a steady income stream. This makes annuities an excellent option for paying senior care costs or just supplementing your savings in your retirement accounts.

Types of annuities

There are three main types of annuities: fixed, indexed, and variable.  Below we’ve laid out the basics of each type of annuity.

Fixed

Fixed annuities pay out a predictable, fixed amount of money. They are often seen as the safest type of annuity, which means they come with the least upside. Generally speaking, money placed in a fixed annuity will accrue about as much interest as a bank certificate of deposit (CD).

Indexed

Indexed annuities provide a bit more upside than a fixed annuity while retaining a relatively low-risk level. These annuities have a guaranteed minimum payout, with some upside potential that’s tied to a large stock market index, like the S&P 500 or the Dow Jones Industrial Average.

Variable

Lastly, variable annuities provide higher return potential at the cost of being the riskiest of the three types of annuities. A variable annuity’s payouts are tied to the performance of a portfolio of mutual funds the individual chooses. This means there can be quite a bit of fluctuation in your annuity payouts depending on how the stock market is performing at a given time.

Pros and cons of buying an annuity

While annuities may sound like a great idea, it’s important to remember that buying them has both benefits and drawbacks. We’ve assembled the most prominent pros and cons of annuities below to make you a more informed purchaser.

Pros

  • Annuities provide a dependable source of income in retirement.
  • There is a wide range of options, making them highly customizable.
  • You may be able to shield your annuity from income taxes through advanced tax strategies.

Cons

  • Annuities do not inherently come with any tax advantages.
  • They often come with commissions or fees paid to the insurance company.
  • You will incur a penalty if you make a withdrawal before age 59.5.

When is the best age to receive annuity payments?

While many things should be considered while shopping for an annuity, the main concern is the age at which you begin to withdraw from your annuity. That’s because the age you start receiving distributions will determine how much money you receive each month.  

The longer you receive payouts from your annuity, the lower the monthly payout will be. That’s why it’s often considered best practice to start receiving payments a few years into your retirement instead of immediately upon retirement.  

Those who delay receipt of annuity payments will have a larger payment each month for a shorter period. People who take payment immediately will have smaller monthly payments for more extended periods.

There is no right or wrong answer regarding when you should start receiving payments from your annuity. But, it’s essential to consider the implications of when you decide to take payment.

Is an annuity a good investment?

Annuities can be a great investment if you’ve fully taken advantage of other tax-advantaged means of retirement saving. IRAs and 401(k) plans allow individuals to grow their wealth tax-free or tax-deferred.  

Annuities do not provide either of these tax advantages, so you might not want to get an annuity until you’ve contributed the maximum amount of money to your 401(k) and IRA plans.

If you purchase an annuity before you maximize your contributions to tax-advantaged accounts, you’ll be paying more income tax than you have to. This means less money will be in your pocket once retirement rolls around.  

Is buying an annuity right for me?

Unfortunately, there isn’t a cut-and-dry answer to this question. This is going to depend on your situation and personal finances. Additionally, deciding whether or not you should purchase an annuity is not a decision that should be made alone. It’s one of many options for funding your retirement, so it is critical to ensure it’s the right choice.

That’s why it’s important to sit down with a certified financial planner or another financial professional to decide whether or not an annuity is right for you.  If purchasing an annuity does make sense for you, they’ll also be able to guide you through the purchasing process and ensure you buy the right type of annuity.