If you’ve maxed out your annual contributions to your 401(k), Individual Retirement Account (IRA), or other tax-deferred retirement accounts, you may now be considering a variable annuity. Before buying one, however, consider all the pros and cons of these complicated insurance products. Here’s a quick overview.
Key points to remember
- A variable annuity can provide a steady stream of income for life, but when you die, the insurance company can keep what’s left.
- If you withdraw funds before age 59.5, you generally have to pay a 10% penalty tax.
- You may have to pay redemption fees if you need to withdraw your money early.
The two categories of annuity
There are two main categories of annuities: immediate and deferred.
With a immediate annuity, you make a lump sum payment and the insurance company starts paying you a monthly income for a certain number of years or for the rest of your life. The amount of payments is based on your age and other factors.
With a deferred annuity, you invest your money in a lump sum or series of payments and watch it grow over time. Earnings on the money you contribute are tax-deferred until you make a withdrawal or start earning regular income.
Immediate and deferred annuities can be fixed or variable. Fixed annuities pay a predetermined amount interest rate on your money, as stated in the annuity contract. Variable annuities invest in a portfolio of what are called “sub-accounts”, similar to mutual fundyou select, and their value fluctuates accordingly.
What is a variable annuity?
So how does a variable annuity work? Well, like many investment products, variable annuities have their pros and cons.
- Investment gains tax deferral—Just like in a traditional IRA, your account grows tax-deferred until you withdraw funds.
- Ease of investment change—Because you select the mutual funds in your variable annuity, it’s easy to change investment focus with little or no cost.
- Income for life—Once you make profitable your contract, which triggers the flow of income, the insurance company will guarantee the payments for the agreed period. It could be as long as the rest of your life and that of your spouse.
- Asset protection-In some states, such as Texas, Florida and New York, annuities are safe from creditors and plaintiffs. If you work in a profession prone to malpractice suits, an annuity may be a smart savings tool for you.
- If you die too soon —Suppose you pay $264,000 into an annuity and, starting at age 60, you receive an income of $1,000 per month in return. You will be 82 when you break even on the contract. If you live past age 82, the insurance company must continue to pay you, but if you die earlier, the insurer usually keeps the remaining funds. Even if you die at age 63, the insurance company keeps the balance of your $264,000. You can buy an annuity that will pay benefits to your spouse or other heirs after your death, but this will cost you more or reduce your own payments.
- Tax penalties—Once you’ve put money into an annuity, you generally can’t touch it until you’re 59½ without paying a 10% penalty tax. When you begin to withdraw funds from the annuity, the portion of your income that is considered an investment gain is taxed at your ordinary income tax rate instead of the long-term capital gains rate, which is generally lower.
It’s getting worse.
The ugly one
- Surrender fees—As if it weren’t bad enough that your funds are tied up until age 59.5, most insurance companies charge a redemption feeusually on a decreasing scale of six to eight years, but sometimes longer. For example, fees may start somewhere around 8% in year one and gradually decrease to 0% in year eight. So a $200,000 investment could cost you $14,000, or 7%, in redemption fees if you had to withdraw your money in the second year.
- Big commissions on sales—Annuities are primarily commission-based products sold by insurance agents and others. When a salesperson tries to sell you the annuity contract, don’t be afraid to ask about the commission they will receive. You can bet that if the agent makes a 5% commission on the sale, your funds will be subject to a redemption penalty for at least five years.
- Costs galore —This is where investors often get burned. Annual and administrative fees and mortality and expenses the charges are buried in the cost of your annuity contract and reduce your profits. According to Annuity.org, the average annuity will charge about 2.3% for all of these expenses, but some rack up charges of up to 3% each year. Mutual funds in sub-accounts will also charge fees, so check the initial fees, fresh 12b-1and others.
As an alternative to a fee-laden variable annuity, consider a mutual fund in a regular taxable account. Your money will be more accessible in an emergency.
Annuities can be a useful place to invest money if you’ve exhausted all other tax-deferred retirement plan options. However, in many cases, it might be better to buy a low-fee mutual fund in a taxable account.
There are many insurance companies that prey on the uneducated investor by charging excessive fees. If you’re invested in an annuity that charges you annual expenses of more than 2.3%, it might be time to get out if you can get away with it without a punitive surrender charge.
For all the rents of bad press due to misleading sales techniques and inadequate disclosure, there are worthwhile products on the market. They are commission-free, have low expenses and no redemption fees, and offer good investment choices. If you have an annuity at heart, shop around until you find the right product at the right price.
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