Annuities can sound enticing when pitched by a salesperson who, not coincidentally, makes huge commissions selling them. To be certain, this unique investment product offers legitimate benefits. Its growth is tax-deferred, and annuities can confer peace of mind by providing a reliable income stream for life.

That said, the disadvantages of annuities are numerous, with a large contingency of financial advisors concurring that the negatives outweigh the positives for this investment vehicle.

Key Takeaways

  • Annuity distributions are taxed as ordinary income, which is a higher rate than that for the capital gains you get from other retirement accounts.
  • Annuities charge a hefty 10% early withdrawal fee if you take money out before age 59½.
  • Salespeople get large commissions from selling annuities, which come at your expense in the form of hidden charges and fees.

Tax Disadvantages

It is true you do not pay taxes on an annuity during its growth phase. The money you earn during this period is tax-deferred. However, when you start taking distributions, not only are you taxed, but the rate is higher than for many investments. Annuity gains are taxed as ordinary income, not as long-term capital gains.

This is especially bad news for wealthy investors in the top tax bracket, which is 37% for 2020 and 2021. By contrast, the profit from investments that receive capital gains treatment is taxed at a much lower 0%, 15%, or 20%.

20% vs. 37%

The upper tax rates for capital gains vs. ordinary income.

Penalties for Early Withdrawal

If you withdraw from your annuity before reaching 59½ years of age, be prepared to pay a hefty penalty. Taking distributions before reaching this milestone generally costs you 10% or more. As annuities are not known as particularly aggressive investment vehicles, the penalty for early withdrawal stands a good chance of wiping out all your gains and more.

High Commissions

The reason life insurance agents pump annuities up to their clients is simple. The commissions from an annuity sale are massive. Furthermore, the money salespeople receive for selling this product does not appear out of thin air. Hidden costs to you, the investor, ultimately provide for the agent’s commission check.

In fact, one of the reasons annuities have such exorbitant early withdrawal charges is that the money helps enable commissions on this product to remain so high.

Advisor Insight

James Liotta, CFP®, CPWA®, AIF®, NSSA®
Prominence Capital GP, LLC, Beverly Hills, Calif.

The disadvantages of annuities depend on the type of annuity. For single premium immediate annuities (SPIAs), cash flow is guaranteed by the issuer for the life of the annuitant. However, the income stream is fixed and does not increase with inflation, and the principal is locked in and no longer available for emergencies.

Many of the added features of SPIAs will also reduce monthly income. In the case of deferred annuities, returns may not be as good as comparable products if the payments are fixed, and they may experience considerable volatility and downside risks if payments are variable.

Surrender charges may also apply for any divestments. Ultimately, it is important to fully understand the features of annuities, all of which have pros and cons depending on the investor’s unique circumstances.