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Annuities: Pros & Cons

Investment Financial Planning

Everyone has a basic understanding of stocks, mutual funds, CDs, T-bills and bonds, but when it comes annuities, many people start to look confused. Unlike more popular ways to save for the future, annuities are insurance products sold for a commission which has always had an air of mystic surrounding them.

This short guide can help you learn some basic information about annuities and offer several of the advantages and disadvantages of owning one.

What Is an Annuity?

Before talking about other aspects of annuities, it is important to first realize that unlike other forms of investments, annuities are often considered a form of insurance by safeguarding the holder an income stream later in life. Annuities allow a person to make a one time payment or a series of payments to guarantee that the holder of the annuity will  receive monthly payments in the future. However, future monthly payments may not keep pace with inflation.

There are two main types of annuities: immediate and deferred. Immediate annuities offer monthly income starting as soon as you purchase it. Deferred annuities start to pay out at a fixed future date. Annuities can provide much needed income for a set period or for the lifetime of the holder depending on the annuity the person owns.

Besides knowing the difference between immediate and deferred annuities, you need to be aware that some annuities are variable, fixed, or indexed annuities.

Fixed annuity. The insurance company promises you a minimum rate of interest and a fixed amount of periodic payments.

Variable annuity. The insurance company allows you to direct your annuity payments to different investment options, usually mutual funds. Your payout will vary depending on how much you put in, the rate of return on your investments, and expenses.

Indexed annuity. This annuity combines features of securities and insurance products. The insurance company credits you with a return that is based on a stock market index or benchmark.

Make sure you know which type you are purchasing. You can find out more about  annuities from the SEC site1 and the NAIC website2.

Benefits of Purchasing Annuities

Annuities provide several advantages for owners, but each annuity is different, and therefore it is essential to educate yourself about the particular annuity you are planning to buy. Besides providing a guaranteed monthly income, most annuities offer:

  1. A way to defer paying taxes on your income. While you can use your 401(k) and IRA to shield some income from being taxed, both have limitations. Annuities are unique in that there are no limits placed on the amount of money you can use to purchase them. Once you purchase an annuity, the interest generated by the annuity is typically tax-deferred.
  2. Protecting your money from probate and creditors. For people who worry about probate fees or have a concern that creditors may seize their assets, annuities can provide a much-needed sense of security. Many states treat certain annuities as a retirement account and are accordingly protected.
  3. The opportunity for your child to qualify for financial aid for school. As long as the owner of an annuity is not yet receiving payouts from an annuity, the government does not require parents to list it as an asset when filling in the Free Application for Federal Student Aid (FAFSA) form. This can help students qualify for need-based financial aid.

The Downside of Annuities

Annuities provide several benefits, but they have their own set of cons which very often outweigh the benefits you need to consider as well. The downside of annuities include:

  1. Paying ordinary tax rates on payouts. While annuities may be a good way to defer paying taxes on income, once you start to receive payouts from an annuity, any payout which is not part of your principal will be taxed as earned income, and therefore will not qualify at lower, long term capital gains rates.
  2. Insurance Companies ability to unilaterally amend terms. Many annuities have a clause in the contract that allow the insurance company to change the terms and features in the contract periodically including your “return”.  These changes can negatively affect your investment. Read your contract carefully to determine what changes the insurance company may make to your annuity
  3. Annuities do not automatically protect you against inflation. A guaranteed monthly income stream may look good today but fall short against future needs. Inflation reduces purchasing power, which is a risk for investors receiving a fixed payment.
  4. Contract fees and expenses may be significant. Whether you are paying the initial commission which can be as much as 10 percent of the total value of the annuity or covering the annual management fee which may reach 1.5 percent or more, annuities are one of the most expensive financial products to purchase. That doesn't even cover the surrender fee which you may have to pay on deferred annuities you need to cash out early.

Be sure you understand all fees and charges before you invest, including:

  • Mortality and expense risk charge. This charge is equal to a certain percentage of your account value, typically about 1.25% per year. This charge pays the issuer for the insurance risk it assumes under the annuity contract.
  • Administrative fees. The issuer may charge you for record keeping and other administrative expenses. This may be a flat annual fee, or a percentage of your account value.
  • Underlying fund expenses. In addition to fees charged by the issuer, you will pay the fees and expenses for underlying mutual fund investments.
  • Fees and charges for riders and other features. Additional fees typically apply for special features, such as a guaranteed minimum income benefit or long-term care insurance. Initial sales loads, fees for transferring part of your account from one investment option to another, and other fees also may apply.
  • Surrender fees. If your circumstances change and you need to access the annuity you may be subject to a surrender fee as high as 10% if you sell or withdraw money from an annuity too soon after your purchase.  This lack of liquidity applies during the "surrender period," typically six to ten years after you buy the annuity.
  • Penalties. If you withdraw money from an annuity before you are age 59 ½, you may have to pay a 10% tax penalty to the Internal Revenue Service on top of any taxes you owe on the income.

Annuities are complex insurance contracts and NOT appropriate for everyone. Always speak with your financial advisor and your lawyer to determine if they are the right option for you.

1https://www.investor.gov/introduction-investing/basics/investment-products/annuities

https://content.naic.org/https://content.naic.org/


This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.