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When planning for retirement, the ultimate goal is to secure a steady and reliable income stream that lasts a lifetime. Annuities and dividend stocks are two common ways to achieve this. Some soon-to-be retirees prioritize security and guaranteed income through an annuity, while others seek growth and flexibility with dividend stocks.
Understanding how these investments work and comparing their risks, costs and tax implications can help you decide which one fits best into your retirement plan.
Here’s everything you need to know.
How dividend stocks and annuities generate retirement income
Many companies, especially well-established ones, distribute a portion of their profits to shareholders in the form of dividends. Retirees who hold dividend stocks long-term can enjoy a steady stream of income without selling shares, while still benefiting from potential increases in stock prices over time. This asset appreciation can help your initial investment outpace inflation over time.
Strong dividend-paying companies also tend to increase their payouts year after year. Over the long run, reinvesting dividends can boost returns even more, making this option a good fit if you’re seeking both income and growth. Most dividend-paying stocks provide income quarterly, but some pay out monthly.
Annuities, on the other hand, are contracts with life insurance companies that guarantee a certain level of income. Annuities offer a predictable payout and protect against longevity risk, or the possibility of outliving your savings.
Annuities generate income either through fixed interest rates or the growth of underlying investments. Fixed annuities offer predictable payouts, while variable annuities and index-linked annuities fluctuate based on market performance. The appeal of annuities lies in the guarantee promised by the insurer — you’ll keep receiving steady payouts, no matter how long you live.
Dividend stocks vs. annuities: How they compare
Annuities and dividend stocks come with different risks and trade-offs that you should carefully consider before deciding which one is right for you.
Weighing your options?
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Annuities vs. dividend stocks: Which is better for retirement?
There’s no one-size-fits-all answer when choosing between an annuity and dividend stocks for retirement. When weighing your options, consider the following factors:
Risk tolerance
- Annuities offer guaranteed income, making them ideal for retirees who want financial security and protection against market volatility — and don’t mind giving up higher potential returns in the process.
- Dividend stocks come with market risks, but provide greater growth potential and the potential to outpace inflation.
Liquidity needs
- Annuities are illiquid and carry penalties for early withdrawals. This makes them much less flexible than most other investments and financial products.
- Dividend stocks can be easily sold at any time, giving you quicker access to cash at a lower cost when you need it.
Income preferences
- Annuities provide a steady income for life. They’re often compared to pensions or sometimes referred to as a “paycheck replacement” due to their predictable payouts.
- Dividend stocks generate passive income but are subject to market fluctuations and potential dividend cuts.
Tax considerations
- Annuities grow tax-deferred, but early withdrawals and a portion of payouts are taxed as ordinary income.
- Dividend stocks, particularly those with qualified dividends, are taxed at lower capital gains rates.
Choosing between an annuity and dividend stocks doesn’t have to be an all-or-nothing decision though.
Some retirees may find a combination of both investments works well. Using annuities to cover essential living expenses, for example, while investing in dividend stocks for additional income and growth can help you create a balanced retirement strategy.
Bottom line
Both annuities and dividend stocks can have their place in retirement planning, but they serve different needs. Annuities offer guaranteed income, while dividend stocks offer growth and liquidity. Annuities are great for security, and dividend stocks for flexibility.
Ultimately, the best approach depends on your specific financial situation, risk tolerance and long-term goals. To make an informed decision, consider consulting with a financial advisor.
