You can compare the answer to this in similar fashion concerning the issue of when you should or shouldn’t buy stocks. You need the wisdom that only comes from doing some serious research about annuities so that you can determine when the time is right for purchasing them based on your financial expectations for retirement. There are several types of annuities such as:

• fixed annuities
• immediate annuities
• indexed and/or CD annuities
• variable annuities

So you should educate yourself as to the different types available, not only to figure out which one will be appropriate for you, but to decide on when you should purchase them.

Typically, the time for purchasing annuities comes about when an investor begins to focus more on income and safety during their retirement years versus growth or earnings yield. The window of opportunity normally occurs about 10 to 15 years prior to when you are planning on retiring. That window widens at the time you retire and then begins to steadily close thereafter.

When is the best time to buy?

Despite the fact that this is a generalization where annuities are concerned, you should still familiarize yourself with the different types listed above. As was previously mentioned, the time to purchase any of these annuities will depend on timing. Here is what we are talking about where timing and type of annuity is concerned:

Fixed annuities – since these are typically a form of fixed income investment, surrender fees will be a standard feature of these annuities, especially when they are the deferred fixed types. Characteristically, you want to purchase these 10 to 15 years prior to when you plan to retire.

Immediate annuities – as the name implies, the time to purchase these is now. In other words, the time to purchase immediate annuities is during the months surrounding you pending retirement.

Indexed and/or CD annuities – typically, these are purchased at anytime during a person’s financial life cycle. However, they are best suited for long-term investing so you should consider getting started with these years ahead of the standard retirement age. These annuities allow the investor to enjoy the gains that occur in the stock market without suffering from losing cycles.

Variable annuities – these are an excellent choice for gaining tax deferrals outside of another retirement plan such as a 401(k) plan or IRA. These types of annuities are not normally a good fit for younger investors as they benefit those individuals who are closer to retirement age. Variable annuities help the investor to preserve these tax deferral options.

Index annuities are annuities based on the value of another investment product unlike most deferred annuities that are based on a specific rate. For stocks, the most common is the S&P 500 index. An annuity based on the value of the S&P 500 index will rise, but never fall with subsequent one-year changes in the value of the index.

Be advised, the way interest works in fixed equity indexed annuities is different than that of traditional annuities. The insurance company writing the note will buy a one year option in the specific index to be tracked. At the end of the one year term, if the index is up from a year ago, then the option is cashed out, and the proceeds are added to the value of the annuity. At that point the insurance company buys another option for the next year. However, if the index has dropped in the one year term, the option is left to expire and no interest is accrued for that year. You can see why these products are so popular as they offer upside with zero downside. Plus, like all annuities, the growth tax-deferred, so you can rack up profits before ever paying a single dime to Uncle Sam.

Before purchasing a fixed equity indexed annuity you’ll have to decide a total investment period as well as the number of years in which you would like to receive a payout. A popular choice is an annuity that allows for a decade of growth before receiving monthly distributions. For example, if you plan to retire at age 70, then you would purchase the annuity at 60 for regular monthly payments at age 70.

You can, however, withdraw your investment in one lump sum following the end of the growth period. For example, an investor who buys a $100,000 annuity at age 60, which then grows to $200,000 at the end of a 10 year growth period can cash out immediately for the full value of $200,000. Beware, some insurance companies carry heavy fees for cashing out, and you’ll also have to pay capital gains taxes immediately. Regardless, the option is always there to cash out.

Should you choose not to cash out before receiving your monthly payouts, your fixed equity indexed annuity will operate just like any other. You’ll receive monthly payouts that correspond with the size of your annuity investment.

Fixed equity indexed annuities are best used by those who have plenty of time before retirement. Since the returns are generally based on a stock index, you’ll want to have enough time to accrue profits before reaching retirement age. Consider the fixed equity indexed annuity as pre-planning a retirement. It’s like investing in an annuity to later buy an annuity. One thing is different, though, and that is that unlike simple brokerage investments that aren’t included in a retirement plan like a 401k or IRA, the annuity grows tax free.

Annuities (specifically deferred annuities) are generally sold by insurance companies, primarily those that issue life insurance policies. Annuities are a natural extension of the life insurance business because the firm has to offer an annuity payout schedule that is based on your life expectancy. Thus, when you purchase an annuity, you’re betting that you’ll live a very long time. Likewise, when you buy a life insurance policy, you’re betting that you won’t live very long, or at least, you’re willing to insure the chance that you won’t live very long.

The tax efficiency of annuities comes from friendly tax codes that allow your investments to grow, tax deferred until you begin to make withdrawals. So, if you were to buy a $50,000 annuity at age 60, and it grows to $85,000 by age 70, you wouldn’t incur a single tax burden until you began to withdraw your principle investment. Your capital gains of $35,000 and your principle investment of $50,000 will be returned at the same time as you begin to receive regular monthly retirement payments.

Let’s assume that you’ve $50,000 saved up and you would like to purchase an annuity. You head to your nearest insurance broker, who likely also sells annuities, and buy a $50,000 annuity. The life insurance company, hedging its bet on your life expectancy, tells you that it will agree to pay you $350 a month until the day you die in return for your $50,000 investment.

As you can already see, annuities offer a higher drawdown percentage than other fixed income investments since the return ends at death. A $50,000 annuity paying out $350 per month has an effective annual payout of roughly 8.4% per year, however you should be sure to note that figure includes some principle. In fact, for the first 12 years, you’ll have your principle investment returned.

When you moderate the annual payout based on your life expectancy, you can see how much you would earn per year. For example, if you made the assumption that you had about 20 years until death, that $50,000 annuity would actually yield about 5.7% annually. Not too shabby.

So, how do you calculate your taxes due? The IRS has made it very simple using a depreciation table. The IRS assumes that at age 70, you’re likely to only live another 16 years. So, in that 16 year period, your annuity will return $67,200 using the same example above, and your taxes would be limited to only that $17,200 over your principle investment.

Your return on investment is just over 25%, so with each annuity payment only 25% of it is taxed at your normal income rate. In the above example, a $350 a month payment would be $87.50 in earnings, and $262.50 in principle. Compare that to a money market account yielding the same 5.7% in which ALL of your earnings would be taxed. As you can see, as a percentage of assets, annuities are taxed at far lower rates than other fixed income investments.

Immediate Annuities

Immediate annuities are those that pay out instantly from the time you sign the paperwork and hand over your investment. In an immediate annuity, the death benefit allows the money still in an annuity to be handed over to a beneficiary if the purchaser dies before receiving the full contract value of the stated annuity. So, if you were to buy an annuity with a contract value of $50,000, and die after receiving just $40,000 in benefits, the beneficiary you picked when signing the deal would receive the extra $10,000.

Deferred Annuities

Deferred annuities are those in which the contract funds generate an interest return, but the purchaser does not receive payments immediately. Often, these are purchased long before the purchaser decides to retire at which point they can slowly add funds to save up, and earn a nice capital appreciation, before regular disbursements are received.

The death benefit in the case of a deferred annuity is generally equal to the money left in the contract as well as interest accrued up until the purchasers death.

You Should Know About Riders

Annuities are a lot like buying a car. Really? Yep. When buying an annuity you can add on all kinds of upgrades called “riders” just like you could add seat warmers and premium headlights to a brand new car.

When shopping around for an annuity, you’ll generally shop for the most basic elements, ie the payment structure, and type of annuity you would like to buy.

After selecting an annuity you’ll have the option to purchase a “rider” or an option on annuity. Riders can vary from insurance protection on your annuity, to an additional death benefit as part of your investment. For instance, you could purchase a $10,000 annuity with a “rider” for $2000 that would allow you to receive a larger death benefit of say, $5,000.

Including a death benefit as part of a rider is a very popular option among annuity investors because they can not only plan for their costs in retirement, but also allow for a lump sum payment to be made at the time of death to cover funeral and other expenses. Talk about an easy way to go!

Adding a rider is done during the “underwriting” stage where the insurance company decides how risky a certain annuity will be for itself. They include things like age, lifestyle, current health conditions and even your credit report to determine how much of a risk you are, and how they will have to price the annuity in order for them to make money. Underwriting frequently becomes more complex as riders are added to the contract, but for many small annuity purchases it amounts to just a tiny step before the cake walk. For larger, more complex annuities, the underwriting process can take more time.

One cannot honestly compare annuities and stocks because they are simply far too different, and serve two entirely different purposes. Stocks are ownership in a company, purchased as a means to generate capital gains and minor income disbursements in the form of dividends. Annuities are the polar opposite, fixed income investments which do not allow for capital gains (except variable annuities) and are geared toward providing an income.

One major difference between an annuity and a stock is the tax schedule. Annuities are taxed just like regular income. So, if you were to purchase a $40,000 annuity that pays out a total of $50,000 in monthly payments, you would owe full income taxes on the $10,000 “profit.” The personal income tax rates go as high as 35% depending on your tax bracket. A $40,000 purchase of stock that rises to $50,000 would create the same taxed income–$10,000–but would not create the same tax burden. The long term capital gains tax is just 15%.

However, annuity taxation should not be the entire basis of your investment decisions, though they should play a part. You should also consider the amount of risk you’re willing to accept with your investment portfolio.

Fixed annuities will provide a guaranteed, absolute yearly return as well as consistent monthly income checks. Annuities are even backed against failure by your own state government!

Stocks will provide an income if they pay dividends (usually a fraction of what you would earn with the same investment in an annuity) but they rise and fall on a daily basis, and do not have nearly the same protection as an annuity.

One final difference are the returns you’d expect to receive from an annuity and a stock portfolio. The US stock markets have historically gained a healthy 10.5% per year whereas annuities perform just over the current triple-AAA rated bond yields. So the difference between the two in returns can be very, very important to overall portfolio performance.

$10,000 invested in a stock portfolio that returns 10% per year would grow to more than $67,000 in 20 years. $10,000 invested in an annuity with a performance of say, 6% per year would come out to $32,000.

As you can see, a 4% difference in yields creates a scenario in which stocks rise more than twice as fast as annuities.

The Bottomline:

If you have plenty of time before retiring (more than 15 years) you’d be smart to invest in stocks, as they’ll allow for quicker, albeit riskier, growth. If you’re nearing retirement and need consistency more than you need returns, then annuities are the way to go.

The bottomline is that too much one or the other will hurt you just as much as too little of each. So be sure to never overweight fixed income investments (annuities or bonds) when you’ve got time to take risks and never overweight stocks when you’re running out of time. If you follow that simple rule, you’ll never mess it up!

The only fair comparison between annuities and mutual funds (especially stock mutual funds) is in comparing periodic-payment annuities and standard stock mutual funds.

Periodic-payment annuities are those that allow you to invest in chunks. Very much like a standard stock mutual fund that allows you to invest as little as $25 monthly, you can invest whatever sum you’d like into a periodic-payment deferred annuity to build up capital until you decide to receive monthly payments. As you can see, annuities and mutual funds are very much similar here.

Where the two investment types diverge is in their performance, and how their performance works. For this example, we’ll use an S&P 500 index mutual fund and a deferred annuity based on the S&P 500. You would think that the performance of the mutual fund and the deferred annuity would be similar, since they track the same investments, but you’d be dead wrong.

Your annuity cannot lose money.

What? Wait! I thought all investments were risky.

Nope, not all investments are created equally. The S&P 500 mutual fund tracks the performance of the S&P 500 index up and down, whereas the annuity based on the S&P 500 index only tracks the index when it moves up.

The deferred variable annuity based on the S&P 500 rises in value with the S&P500 but only to a certain degree. You see, your annuity broker will promise to protect you from stock market drops, but they also limit your upside. For example, if the S&P500 index were to rise 15% in one year, your S&P500 mutual fund would appreciate by 15% where your annuity may rise the maximum cap of 7-10%. However, if the S&P500 were to plunge 20%, your annuity would lose nothing and your mutual fund would lose the full 20%. When the stock market is performing well, the mutual fund will outperform the annuity, but in bear markets your annuity will perform better.

Finding common ground

Investing in stock mutual funds at 65 is like betting on horses to secure your retirement. Likewise, investing all your money in an annuity at 20 is equivalent to stocking all your cash under a mattress for extreme safety. Both can be used in conjunction with one another, and effectively as well.

Conventional wisdom is to take 100, subtract your age from it, and that is the amount you should have invested in stocks, the other part should be in fixed income. A 30-year old, for example, should invest his or her money 30% in fixed income (like an annuity) and 70% in stocks. At 40, that same person would invest 10% more in fixed income and 10% less in stocks. Simple, right?

A proper balance of annuities and stock mutual funds will allow for solid capital appreciation as well as safety in turbulent markets. It isn’t about one or the other, its all about a proper blend of both at just the right time.

For them, it’s just business. For you, well, it’s just business too. You have to decide which is a better investment, and how to allocate your money for each. The thing is, you only have a limited amount of money.

First you need to decide how much life insurance you should have. I should mention that many people are either grossly uninsured, or grossly overinsured. That is, having far too much or far too little insurance for their needs.

If you’re young, have a family, and a spouse that absolutely cannot live without your income then you need to have a lot of life insurance. Imagine, one day you just don’t wake up, you’re dead as a doorknob just a few years after buying a house—a purchase made on the premise of having two incomes. While for the first few days it will be an emotional strain as loved ones grieve, the next few decades will be even more difficult as your spouse struggles to pay for the expenses of a family without you.

In this case, you absolutely need to have enough life insurance to cover expenses for your children and living costs for your spouse. In many instances, couples get away with planning to have enough money to pay off the mortgage, cars and other debts, as well as college expenses for children and funeral costs. The good news is that because you’re young, buying enough insurance to cover it all will be insanely cheap.

However, if you’re older, or just in your twenties, buying too much life insurance is a huge problem. When you’re 65, you’re kids are out of the house and your home is paid off, there is little reason to have any more life insurance to pay for funeral costs. You might not even want to have that insurance at all!

At 20, single, and searching to start your career, you probably want just enough to cover funeral expenses. Though be sure to ask mom and dad, you might already be covered by a policy they owned since your childhood.

Annuities

Annuities are something that you should start thinking about as you near retirement age. Whereas life insurance was a really good deal as a 30 year old with a wife and kids, it isn’t any more. Now your best investment is in yourself, and your standard of living, until the day you die.

At this point, life insurance will be horribly expensive. So, if you haven’t yet covered the cost of an expected funeral, or haven’t preplanned, then you may want to seek out an insured annuity. With an insured annuity, you’ll get the remainder of your annuity’s balance at the end of your death. This is most often used to cover funeral and burial costs.

Your best bet is to reduce your life insurance while kicking up contributions made into a retirement plan or annuity. As you age and advance through the milestones of life, you should be reducing your total insurance needs and increasing your retirement planning. An annuity is an excellent replacement for monthly life insurance premiums and by the time you retire you’ll be more than happy you saved a few extra dollars.

An IRA is an individual retirement account in which you can put financial instruments like stocks, bonds, CDs, and annuities to save tax free toward your end retirement goals. One popular choice is the Roth IRA, wherein you deposit after-tax income to allow your investment to grow tax free, and be withdrawn tax free forever. This is a very popular choice among investors because you pay your taxes up front, and even if the tax rates keep going higher (as they have been) you’ll have already paid your share to Uncle Sam. That’s a pretty sweet deal!

A Roth IRA, just like an annuity, will allow you to grow your money tax-free, and even allow you to save post-tax income without paying more in the future.

So, if you’re looking at both an annuity and an IRA, open both. You’ll be happy you did.

One great way to use them in tandem is to buy a periodic-payment deferred annuity within your individual retirement account, or IRA. Don’t worry, the explanation for how periodic-payment annuities work is actually shorter than the name.

Periodic-payment deferred annuities allow you to build up a retirement income source over a period of time. With the periodic-payment deferred annuity, you are basically funding your own personal pension program, adding money every month, quarter, or even paycheck to grow your total monthly payment when you retire.

Some investors like to start saving in an annuity at a young age, putting just a few dollars in each month to start building up a very safe, very secure, investment for the future. Others, who already have an established retirement fund, like to transfer their income into a annuity as they age, protecting more and more of their assets against downside risk. Wait, we didn’t cover that part…

Annuities, unlike other investments, are actually protected against lost. First, they inherently can’t lose money as part of the contract you sign with the insurance company when you purchase them. Second, most are protected up to as much as $250,000 by your state government. So, should the company writing the policy go bankrupt, your state government will cut you a check for the value of your annuity up to the maximum insured. Pretty cool, huh?

But you’ll also be able to grow your money, not just protect it. In a periodic-payment deferred annuity your returns will be indexed to the stock market, allowing the amount of money you invest to grow, while protecting you from downside. Often, in years of excellent stock market performance, you’ll get anywhere from 7-10% added to your account. In years that the stock market dips, you won’t have any money subtracted from your account, but you won’t have any added either. All in all, annuities make excellent investments, and it would be wise for those nearing retirement to start considering a move from their mutual fund based IRA into an annuity.

Where the two products diverge isn’t in their returns, nor their prices or options, but in their inner workings. Annuities are a simply a bet made with an insurance company, usually a life insurance company, that you will live a very long life…one long enough to collect more in monthly payouts than you paid for the policy. Bonds, on the other hand, are an investment in the debt of a business. When you buy a bond, you’re buying nothing more than a promise from a company to pay you back a certain amount of money plus interest.

One benefit to bonds is that you’ll get your money back even if you die, whereas uninsured annuities stop payment upon death. Another benefit is that you have some safety when buying a basket of bonds either through an exchange-traded fund or a mutual fund. Since most individual bond purchases are made in blue-chip companies, you also have a very good chance of repayment, with little risk of default. However, on the downside, defaults on bond payments do happen, and many times they happen abruptly, with little warning.

Just think for a second. During the roaring 2000′s would you have ever expected that General Electric or General Motors would ever be on the brink of bankruptcy? Did you ever think the value of their bonds would ever plummet, or in GM’s case, go to zero? Never. They were both well financed firms with great management, but eventually their expansions lead to serious financial pitfalls.

When safety matters most, many investors opt to choose annuities. By purchasing an annuity, your payout is guaranteed never to fall, and is even insured by your state government up to a certain investment total. That is, for each individual annuity policy that you may own, the government will insure it up to a set dollar figure by law. So, even if the writer of the policy were to disappear overnight, you’d be guaranteed to get your investment back. And that, of course, is one huge benefit.

On the flipside, you’re likely to pay more in annual expenses on an annuity than you would a corporate bond mutual fund. Also, for uninsured annuities (uninsured annuities are generally a far better investment than insured annuities) your payments will cease when you die. So if you were to buy an annuity on Monday and die on Wednesday, you’d have nothing. If you were to buy a bond on Monday and die on Wednesday, you’d still own the bond, at least, your heirs would.

When it comes down to it, equity indexed annuities and bond portfolios have virtually the same amount of risk as well as reward, but with annuities you have just one more layer of protection in default insurance from your state government. We’d recommend you opt for both a blue chip bond fund as well as an annuity.

Stocks and bonds generally trade in opposite directions. Stocks fall when bonds rise, and bonds rise when stocks fall. So, in knowing that, you could practically arbitrage the market by purchasing both an annuity indexed to stock performance and a bond portfolio indexed to, well, the performance of the bond market. When bonds rise, your annuity will stay put, protected from downside risk. When stocks rise, your annuity will rise in value while your bond fund will drop in value. Just some food for thought.

It is obvious from the comparison that you’re looking for a solid, predictable, fixed income investment, likely for retirement income. You’ll find that both annuities and CDs are very different, but for practical purposes are very much the same.

Annuities, especially prepaid and insured annuities (those that pay until the day you die) allow for greater predictability. Since you know you’ll be receiving a fixed payout for the rest of your life, you won’t have to worry about running out of money as you would with CDs. Also, annuities allow you to draw down on your principal without any concern. You can’t say that for certificates of deposit.

One last benefit of fixed annuities is that you won’t have to deal with the fluctuations in interest rates. CDs that yielded as much as 5-6% during the early 1990′s are now yielding less than half a percentage point in 2010. So, ask yourself, is that the kind of volatility you want in your retirement income? What if you had retired at the age of 65 in 1990, making more than 10 times the income then as you do at 85? Prices have surely risen since 1990, especially in health care, food, and energy prices, all of which you’ll consume the same, if not more at 85 than you would at 65.

Oh, and we didn’t even touch taxes! Growth in the accumulation phase of an annuity is tax free. You only pay as you make withdrawals.

CDs have benefits too

CDs certainly have their own benefits over annuities. First, certificates of deposit allow you to keep your principle investment while collecting interest monthly, quarterly or annually. Another benefit, if you have enough cash to make it through, is that upon your death you’ll be able to pass the principle investment onto children, grandchildren, who can set it aside for funeral and burial costs or even to start a college fund for the youngsters. It’s hard to put a price on generational wealth.

One major benefit is that should live less than your life expectancy, you’ll still have cash leftover. With annuities, the payouts cease at the time of death, and you’ll have lost everything unless you have insured your plan, or it allows for a cashout at death. Annuities that have the cashout option are generally more expensive, so you’ll have to price that in to your planning.

Get the best of both worlds!

We’d recommend that if possible, consider investing in both annuities and certificates of deposit. This way you’ll be able to get consistent cash payments from your annuity, as well as generate passive income from your CD investments.

Diversifying your wealth into both investments is a smart decision. You’ll have the safety of annuities as well as the opportunity to take advantage of high interest rates with CDs during the good years. Even into retirement, diversification is still very important, and you wouldn’t be wrong to invest in both.