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Perhaps you’ve heard there is a “retirement crisis” in America. Traditional pension plans currently play a big role in today’s retiree budgets since they provide a predictable income throughout a person’s retirement. But pensions are being phased out for most future retirees. And since many of those retirees have not saved enough for retirement, they want to replace that source of steady income any way they can.
Annuities: Pros and Cons
Annuities seem to fit the bill perfectly. They are basically savings accounts with an insurance company designed to provide a guaranteed lifetime income. That sounds pretty attractive for someone who needs to stretch their savings over a 20–30-year retirement.
But Dave isn’t a fan of annuities, and there are plenty of reasons why. One of the main reasons is that annuities have significant expenses that reduce the growth of your investment. Annuities also have surrender charges on early withdrawals that can limit access to your money in the first few years after you buy the annuity.
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Annuities vs. Mutual Funds
In general, annuity rates of return are higher than rates for certificates of deposit (CDs). So for guaranteed growth and protection of principal, annuities win out over CDs. But those guarantees also mean lower returns than you could get by investing in the stock market with mutual funds.
A typical fixed annuity may offer a 5% guaranteed annual payout with 1.15% in annual fees. That lowers your actual return to just 3.85%. With good growth stock mutual funds, you can earn much higher rates of return—as much as 12% based on the market’s long-term historical average.
Using those figures, a $10,000 fixed annuity will grow to $32,000 in 30 years at 3.85%. But a $10,000 mutual fund investment could grow to almost $360,000 in 30 years!
In addition to fees, you’ll also need to consider taxes. In most cases, growth of funds in an annuity is taxed at your ordinary income tax rate when you withdraw the money. But when you invest in mutual funds through a Roth IRA like Dave recommends, you can withdraw that money tax-free in retirement.
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Keep Your Head and Stick to the Plan
The bottom line here is that while a guaranteed income is great, your earnings potential is much greater with mutual funds. Stick to a simple plan: Invest 15% of your income in mutual funds through tax-advantaged accounts such as your 401(k) or a Roth IRA.
If you make the average annual salary of $40,000 and have at least 25 years to invest, this plan could leave you with $950,000 by the time you retire. But you must remain disciplined and keep a long-term outlook, no matter how the stock market behaves.
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