Carrie Schwab Pomerantz

Dear Carrie, My mother, who is in her 70s, has recently been advised by her banker to buy an annuity. I've heard that annuities can be costly and risky. What do you think? --A Reader

Annuities often seem to raise questions. That's probably because what was once a fairly straightforward way to secure income for retirement has evolved into a multitude of products with an array of possible features. As a result, the world of annuities has become incredibly complex and fraught with potential misunderstanding.

Annuity basics

Annuities can be divided into two distinct categories: fixed and variable. Both are contracts with an insurance company; you pay a premium (or series of premiums), and then receive payments at regular intervals for a stated period of time.

There's no limit to the amount you can contribute to an annuity, however, contributions aren't tax deductible. Taxes on earnings are deferred until you withdraw the money, at which time you pay ordinary income taxes on your gains. There's a 10 percent penalty for withdrawing earnings before age 591/2, but there is no required starting age for withdrawals.

At a basic level, a fixed annuity may seem like a traditional pension plan, providing a predictable income stream. Provided the insurance company remains solvent, you can count on receiving payments for a set number of years, for life, or even for the life of a beneficiary.

With a variable annuity, however, you can invest your money in "subaccounts," which are comprised of stocks, bonds, or other vehicles -- and your return will vary depending on their performance. For that reason, payments aren't as safe or predictable as they are with a fixed annuity.

Adding another level of complexity, both fixed and variable annuities can be either deferred or immediate. With a deferred annuity, payments start at a future date. An immediate annuity will start to pay out right away, continuing for a specified period of time or for life.

Annuities can have hefty fees and commissions, whether variable or fixed, but that doesn't mean your mother should avoid them. In particular, an immediate fixed annuity, also known as a single premium immediate annuity (SPIA), could work well for someone your mother's age under the right circumstances.

SPIA basics

With an SPIA, you invest a lump sum with an insurance company and immediately begin to receive guaranteed income for a set number of years or for life, depending on the annuity. It can be a viable way to supplement retirement income. With a life annuity, there's the added security that you'll never outlive the income.

Beyond the basics: Is an SPIA right for everyone?

Carrie Schwab Pomerantz

Carrie Schwab Pomerantz is a Motley Fool contributor.

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