If you’re considering using your retirement savings to buy an annuity, it’s vital to understand exactly how they work, so you can be certain you find the best possible deal.

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An annuity pays you a guaranteed income, usually for the rest of your life. Here’s what you need to know.

1) You don’t have to buy an annuity from your pension provider

You should always shop around when buying an annuity, as you might be able to secure a higher income from an alternative provider. It’s still worth checking what your own provider will offer, so that you can see how other rates compare.

2) There are lots of different types of annuity to choose from

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There are several kinds of annuity available, so you need to think carefully about which type might be suitable for you before buying.

  • Standard annuity: With a standard annuity the level of income you receive every year is fixed. You’ll be paid this level of income until you die.
  • Enhanced or impaired annuity: If you suffer from a medical condition, or you’re a smoker, you may be eligible for an enhanced or impaired annuity. This will entitle you to a higher level of income because your life expectancy will be considered shorter.
  • Fixed term annuity: As the name suggests, a fixed term annuity pays you an income for a set term, typically up to five years, rather than until you die.
  • Index-linked annuities: An index-linked annuity provides an income that increase each year in line with inflation, so your payments keep pace with rising living costs.
  • Joint life annuity: A joint life annuity will provide you with an income until you die, at which point a proportion of this income is then paid to your spouse or another chosen beneficiary until they die.
    It’s a good idea to seek professional advice if you’re not sure which type of annuity might suit you best.

3) The income from an annuity is taxed as normal income

You can take the first 25% of your pension pot tax-free, but you’ll be charge income tax on any other money you take from your pension. The amount of tax you’ll have to pay depends on your total income for the year and your tax rate.

4) The money you use to buy an annuity will be gone when you die

Once you’ve swapped your savings for an annuity, you can’t get your money back. If you live a long time, then you may get back more than you actually paid the annuity provider, but if you only live for a few years, you’ll only benefit for a short time and the provider gets to keep the rest of your money.

5) An annuity isn’t the only way to get an income from your pension

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Changes to pension rules back in 2015 mean that there is now a much wider range of options when it comes to taking an income from your retirement savings. For example, you can use your pension pot to provide you with a flexible retirement income via pension drawdown. This involves leaving your pension invested and drawing an income from it as and when you needed. Unlike an annuity however, your income isn’t guaranteed and may depend on how your investments perform.

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