Investors like you have become more sophisticated over the years - and so have the types of annuities you have to choose from. Just as mutual funds grew in popularity as an alternative to CDs, the variable annuity was developed as an alternative to the fixed annuity. Variable annuities offer potentially higher returns than fixed annuities. Of course, there is a risk of loss as well.

Deciding which type of annuity is right for you often comes down to deciding how much risk you are willing to take. Ready to dive in? Let's see which type of annuity is right for you.

Lower Risk with Guaranteed Growth: Fixed Annuities

When you buy a fixed annuity, you'll fund it over time with monthly payments. That money earns interest as you continue to make your payments. The interest rate your annuity provider offers will reflect current rates and may change periodically.

When you're ready to retire, you'll notify your annuity provider, and instead of making payments, you'll start receiving them instead. In most cases, clients choose to receive a monthly check that will keep coming until they pass away. Your annuity provider guarantees the amount you will receive per check, so you never have to wonder exactly how much money will be coming.

So what's the downside? Well, the only potential problem is that your fixed payment may lose purchasing power over time due to inflation. Some retirees are hesitant to commit to a fixed annuity payout rate for this reason. Others are perfectly happy to keep their money safe and secure with that guaranteed rate. The choice depends on your financial goals and your tolerance for risk.

Higher Risk with More Growth Potential: Variable Annuities

When you buy a variable annuity, the annuity issuer offers you a choice of investment options in what are known as "subaccounts." For example, you may be offered a choice of stock, bond, and money market funds. Your annuity provider doesn't guarantee or predict any rate of return. Instead, the return on your annuity investment depends entirely on the performance of the investments that you select. Your return might be more than it would be with a fixed annuity. On the other hand, it might also be less.

When it's time to start receiving payments from your variable annuity, you can choose either a fixed payout (like the one you'd get with a fixed annuity, as described above), a variable payout, or a combination of the two. If you select a variable payout, the amount of each payment will depend on the performance of your investment portfolio. If the portfolio increases in value, then your payments will increase as well.

Most annuity issuers offer a third option that allows you to lock in a minimum fixed payment every month, with the possibility of an additional variable payment based on the performance of your investment portfolio. By allowing your principal to remain in investment accounts during the distribution phase, you have the continued opportunity to benefit from rates of return that are higher than what would have been received with a fixed annuity.But remember, you also run the risk that your payout could be lower if your investment choices do not perform well.

Which Is Better for You?

That depends on your ultimate financial needs and goals. Annuities are long-term savings vehicles used primarily for retirement. There are many advantages to annuities, but there are  a few drawbacks, too. These include a 10% tax penalty on earnings distributed before age 59½, and the fact that all earnings are taxed at ordinary rather than capital gains rates. If an annuity is right for you, then the choice between fixed and variable annuities will depend on your situation and preferences.

Usually, choosing between the two comes down to your risk tolerance and the amount of control you want over investment decisions:

  • With a fixed annuity, there is little risk. You know what you're going to get out of the annuity. However, the growth potential of a fixed annuity is limited.
  • A variable annuity, on the other hand, has a much greater potential for growth (although with this growth potential, there is a greater potential for loss). You also have the opportunity to make the investment decisions that will impact the growth of your annuity.

The amount of risk you can comfortably accept, along with your ability to manage your investment, will help you choose between a fixed and a variable annuity.

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