Choosing Annuities for Large Sums of Money

If you've come into a large sum of money, and have several years to make use of it, an annuity might be a suitable investment. It's perfectly fine to use part of the money to top off your 401(k) and IRAs first, but the amount you can contribute in those accounts is limited. With annuities, you can invest an unlimited amount of money and have it grow tax-free until your retirement. You don't get to deduct your contribution from this year's taxes, but when you begin to draw a retirement income from your annuity, you'll only pay taxes on the percentage of it that's profit.

Fixed annuities are the "hands-off" option for investors. Your money is added to the issuer's institutional pool of investments and grows with its portfolio. When you convert the annuity to income you'll receive the higher of their guaranteed rate or their investment rate. Variable annuities are more flexible. They invest in conventional products such as mutual funds, holding them in subaccounts. Over the long term they'll usually give better returns than a fixed annuity, but if your investments go down it could reduce your payout. Variable annuities often include a guaranteed minimum return as a selling feature, limiting your risk.

With so many positives, you might wonder why everybody isn't buying annuities. One reason is that annuities give lower returns than other investments because of their costs. They're usually sold by brokers who earn commissions of up to 10 percent. And their management costs are high because they contain an insurance component (they may guarantee you against investment losses, or guarantee future income, or both) as well as the investment. They're also costly if you need to take money out. During the first seven to eight years of a contract, withdrawals typically incur "surrender fees" that can go well into double digits. Any earnings that you withdraw are taxable, and your withdrawals are subject to an additional 10 percent tax penalty if you're less than 59 1/2 years old.

Your investment goals should determine your annuity choice. If a fixed annuity will give you all the income you need in retirement, alone or in combination with your existing portfolio, then it's a safe and conservative choice. You'll have a guaranteed income until you die, regardless of how long you live or what the markets do. However, if you're looking for better returns, building a diversified portfolio in a variable annuity might be the better option. Compare the management and surrender fees of the annuities you're considering. Some companies sell directly to investors, rather than through brokers, which can save a substantial amount in fees.

You don't have to decide how to take the payout from your annuity when you buy it. That can wait until you retire, so that's when you need to make the decision. For example, you might want to draw an income from part of the annuity and leave the rest intact. That became an option in 2011, and is available in many annuity products. You might choose to roll over the annuity into an IRA, which allows you more flexible withdrawal options. The most common alternative is to take periodic payments, as a monthly or quarterly income. The payments can be drawn for a set period, or until the end of your life.