What Does Annuitization Mean and Should I do it?
Contrary to what many people think, annuities and annuitization are not the same, and confusing them can cause BIG problems for your retirement plan.
WHAT IS AN ANNUITY?
An annuity is a financial product. Technically, an annuity represents a contract made between the insurance company and the person who bought the annuity.
When you purchase an annuity, you can make a one-time payment for it.
In exchange, the insurance company promises to provide some sort of benefit.
ANNUITIES ARE OFTEN A RIPOFF
The definition of an annuity can make them sound great. But they’re usually best to avoid.
Annuities typically have high fees which reduce your investment returns.
Consider two hypothetical investments:
- A low-cost index fund with a nominal fee
- An annuity with a 2% annual fee
Assuming a 7% rate of return on each, investment #1 will end up with 2x as much money as investment #2 over a 30 year period.
There are some exceptions when annuities can be beneficial. One is the single premium immediate annuity. The SPIA usually has low fees and can be a good way to guarantee future income. Annuities may also make sense for individuals in very high tax brackets that have already maxed out their tax-advantaged savings for the year. In this case, the high fees on the annuities can be offset by the tax advantages offered by these high-fee products. But, for the most part, annuities are expensive financial products not worth considering.
WHAT IS ANNUITIZATION + SHOULD I ANNUITIZE?
Annuitization is the process of converting a sum of money into a monthly income stream for a certain time period.
THE ADVANTAGES OF ANNUITIZATION
You could use annuitization as forced budgeting.
Let’s say you have a $500,000 annuity. You’re fearful that you will spend it all at once and want to put some guardrails in place.
One solution might be to annuitize your annuity. Doing this will only give you access to a small slice of your annuity each month/year.
GIVE YOURSELF A TAX BREAK
Annuitization can also be used as a tax strategy. Receiving a lump sum of money can trigger adverse tax consequences. Choosing to annuitize can decrease that tax burden.
Again, say you have $500,000 — but you choose to use annuitization to distribute $25,000 per year to yourself over 20 years. And that relatively smaller distribution of $25,000/year prevents you from being pushed up into a higher tax bracket.
WHAT TO WATCH OUT FOR IF YOU ANNUITIZE
Of course, annuitization has risks. This includes company risk, market risk, and illiquidity risk. When making decisions, consult a fiduciary advisor to see what risk you will be most comfortable with.
When you annuitize, you put all your financial assets under the management of the company offering the annuity.
If that’s your previous employer, it may not hurt to research your employer’s pension to figure out how much money they have on the books. Is the pension underfunded? That’s likely the case with many pensions today.
STOCK MARKET RISK
If you decide to take a one-time payment, you’ll be investing the money yourself. As with any investment, that carries risk.You’re trading the risk the pension goes insolvent for that of the stock market.
When you annuitize, you’re forced to settle for whatever annual payment you’re given. If you need cash due to an unforeseen event, that’s too bad. You can’t access the original pot of money when you annuitize.
Annuitization can offer many benefits over taking a large amount of money all at once. But there are also major drawbacks to consider.
The decision, of course, is personal. Just be sure to do your research and ask a lot of questions before making it.
As fiduciaries, we’ve taken an oath to prioritize your financial well-being above all else. We’ll treat you with the honesty and integrity you’d expect from someone with whom you are entrusting your future
Joseph Vecchio, CPA, CFP®, MBA, the founder of Shore Financial Planning, started his investment career in 1998 as a professional trader/money manager on wall street. He believes in a passive investing style founded on academic evidence.
Joe takes pride in protecting people from financial predators and helping them make smart financial decisions. We will provide you peace of mind through conflict-free, value-added financial, and tax advice.