Worried you'll outlive your retirement savings? An annuity might be the answer

Annuities can provide important sources of monthly income that many retirees rely on in addition to Social Security, 401(k) savings, and pensions, and can provide the flexibility to decide when to begin receiving distributions, as appropriate.

An "annuity" is a contract with an insurance company. You invest in an annuity with either a series of payments or a lump sum payment. When you are ready, the insurance company then provides steady cash flow to you for a specific time period. Often, people invest in annuities to reduce the risk that they will outlive their retirement savings.

TD Bank offers some key facts to consider when investing in an annuity.

There are different types of annuities

There are several different types of annuities, and each has unique features and benefits to consider. Three common types include:

• Fixed annuities – You will receive a fixed interest rate set by the insurance company for a fixed amount of time (typically 3-7 years).
• Indexed annuities – Instead of a fixed rate, you will earn interest based on the performance of a specified market index, such as the S&P 500. The minimum return set by the insurance company on an index annuity is 0% so even if the S&P 500 is negative for the year, you will not realize any loss. There are usually caps also set by the insurance company on the "upside" as well. So, if you have a cap of 5%, and the S&P 500 is up by 8%, you will only realize a 5% gain.
• Variable annuities – Your money is invested in a portfolio of mutual funds within the annuity product. Returns are not guaranteed, and the annuity may lose value. Performance is dependent on market performance. There is an opportunity to experience gains or losses greater than in a fixed or indexed annuity.

Your money grows tax-deferred

While your money is in the annuity, interest grows tax-deferred. This means you will not pay tax on any interest earned until you withdraw money from the annuity. As such, you will earn interest on your money, interest on your interest, and interest on the money you would have paid in taxes.

Annuity distributions are taxed differently depending on how the account was funded. An annuity can be funded with either pre-tax money or after-tax money. These are referred to as either qualified or non-qualified annuities.

Qualified annuities are funded with pre-tax contributions and are usually made from an IRA or 401(k). Distributions from qualified annuities are taxed when you receive distributions.

Non-qualified annuities are funded with after-tax contributions and are usually made from your checking or savings accounts. The taxation of distributions from non-qualified annuities typically applies only to the interest earned.

You must name a beneficiary for your annuity

An important aspect of annuities to consider is that you must name a beneficiary for your annuity. Upon death, any existing death benefit is paid directly to your beneficiaries, which allows them to receive your financial legacy without the cost and delays of probate.

Annuity risks

Fixed and indexed annuities are generally considered "low-risk," although the degree of risk will vary depending on the annuity type. Annuities are a longer-term investment and early withdrawals (before the end of the term), can lead to surrender charges. Because annuities are given preferential tax treatment for retirement planning, money withdrawn prior to age 59 ½ is currently subject to a 10% IRS penalty. For this reason, annuities are generally recommended for people age 50 and over.

It's important to remember that although annuities are available through many banks by insurance-licensed professionals, they are not bank products nor guaranteed by the bank. They are issued by insurance companies and are not FDIC-insured. They may also lose value.

It can be beneficial to have a conversation with a financial advisor before investing in an annuity. An advisor will help you select an annuity based on your risk tolerance, time horizon, financial need, and other factors. 

You should also have an emergency fund

As mentioned above, because annuities are longer-term investments you could be charged a surrender penalty for early withdrawal. Additionally, if you put all your retirement money in an annuity, you may not be able to access enough money to cover unexpected expenses like vehicle repairs, medical bills, or home maintenance issues without incurring a penalty or surrender charge. Therefore, it is important to make sure that you have an emergency fund set aside to draw from in case you need money in the short term.

This story was produced by TD Bank and reviewed and distributed by Stacker Media.