If you think the tax-deferral of an annuity is good for your financial situation, you still have a second decision to make before you start looking for the best product. Do you want a fixed or variable annuity? A fixed annuity offers you the security of never worrying about the fluctuations of the stock market, but the variable gives you more potential for growth.
Fixed Annuities
Fixed annuities are similar to CDs with a tax shelter. Like a CD, you receive interest on the money you invested, but it grows tax-deferred. Unlike a CD, you can annuitize the account, which turns your lump sum of money into payments for a specified period, specific amount, or lifetime of payments, no matter how long you live. If you don't annuitize, you can add more money to the annuity whenever you like, which you can't with a CD. Initially you have a guaranteed rate, but after the guarantee period the rate changes, just as it would if you allowed a CD to roll.
Variable Annuity
Investing in a variable annuity is similar to investing in mutual funds. The variable annuity contains subaccounts as investments that are similar to mutual funds. In fact, many of the subaccounts have the same name as the mutual funds they mirror. Just like in a mutual fund, your principal balance fluctuates with the market returns. If the market is too unpredictable, you can transfer some of your funds to a fixed investment inside the annuity, or a money market account that doesn't fluctuate. Unlike the fixed annuity, you have a wide selection of investments.
Inflation
Annuities are retirement vehicles, just like IRAs. In fact, if you take money out of an annuity before you're 59 1/2, you pay the same 10 percent penalty on the growth as you would with a Roth IRA. The difference is that in a Roth, you can call the initial withdrawal the principal. In an annuity, the growth always comes out first. This means, if you're young and use a fixed annuity, you experience inflation eroding your buying power. While the cost of living might increase four percent, you don't make anything if you only receive a three percent return; in fact, you lose buying power. Variable annuities allow you to invest in stock mutual funds as part of their portfolio, which keeps up with inflation.
Guarantees
Your principal is safe in a fixed annuity. It doesn't fluctuate, but simply gains interest. However, you have no guarantees on the interest after the initial rate guarantee disappears. Variable annuities have riders, some of which guarantee a specific interest rate on your account. That rate might be as high as seven percent. Of course, you have to take specific steps, such as leave the funds in a certain length of time, to receive the guarantee. These riders also cost a specified percentage of your balance each year. The cost is normally between one, and a fraction of a percent.