If you have maxed out your annual contributions to your 401(k), IRA, or other tax-deferred retirement accounts, you may now be considering a variable annuity. But before you buy one, consider all the benefits and shortcomings of these complicated insurance products. Here is a quick rundown.
- A variable annuity can provide a regular income stream for life. But when you die, the insurance company can keep what's left.
- If you withdraw funds before age 59½, you usually must pay a 10% tax penalty.
- You may have to pay a surrender fee if you need to get your money out early.
The Two Categories of Annuity
There are two broad categories of annuities: immediate and deferred.
With an immediate annuity, you make a lump-sum payment, and the insurance company starts paying you a monthly income for a specified number of years or for the rest of your life. The amount of the payments is based on your age and other factors.
With a deferred annuity, you invest your money in a lump sum or a series of payments and watch it grow over time. The earnings on the money you contribute are tax-deferred until you make a withdrawal or start taking a regular income.
Both immediate and deferred annuities can be either fixed or variable. Fixed annuities pay a predetermined rate of interest on your money, as spelled out in the annuity contract. Variable annuities invest in a portfolio of "sub-accounts," similar to mutual funds, that you select, and their value fluctuates accordingly.
Like many investment products, variable annuities have their upsides and downsides.
- Tax deferral of investment gains. Just as in a traditional IRA, your account grows tax-deferred until you withdraw funds.
- Ease of changing investments. Because you select the mutual funds in your variable annuity, it’s easy to change investment direction at little or no cost.
- Income for life. Once you annuitize your contract, which starts the flow of income, the insurance company will guarantee payments for the agreed-upon period. That could be the rest of your life and your spouse's life if you choose.
- Asset protection. In certain states, annuities are sheltered from creditors and lawsuit plaintiffs. If you work in an occupation that is prone to malpractice suits, an annuity may be a smart savings tool for you.
- If you die too soon. Say you put $264,000 into an annuity and, starting at age 60, receive income of $1,000 per month in return. You'll be 82 by the time 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 typically keeps the remaining funds. Even if you die as early as age 63, the insurance company retains the balance of your $264,000. You can buy an annuity that will pay benefits to your spouse or other heirs after you die, but that will cost you extra or reduce your own payments.
- Tax penalties. Once you put money into an annuity, you generally cannot touch it until you reach age 59½ without owing a 10% tax penalty. When you do start to take 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 usually lower.
It gets worse.
- Surrender charges. As if it’s not bad enough that your funds are tied up until age 59½, most insurance companies charge a surrender fee (usually on a diminishing seven- to eight-year scale, but sometimes longer). For example, the fee might start somewhere around 8% in the first year and gradually decline to 0% in year eight. So a $200,000 investment could cost you $14,000, or 7%, in surrender fees if you needed to take your money out in the second year.
- Big sales commissions. Annuities are primarily commission-based products sold by insurance agents and others. When a salesperson attempts to sell you the annuity contract, don’t be afraid to ask about the commission that person will collect. You can bet that if the agent is making a 5% commission on the sale, your funds will be under a surrender penalty for at least five years.
- Fees galore. This where investors often get burned. Annual fees and administrative/mortality and expense charges are buried in the cost of your annuity contract and take away from your profits. The average annuity will charge around 1.4% for all these expenses, but some rack up fees as high as 2.5% every year. The mutual funds in the sub-accounts will charge fees, too, so check for front-load fees, 12b-1 fees, and others.
As an alternative to a fee-laden variable annuity, consider a mutual fund in an ordinary, taxable account. Your money will be more accessible in an emergency.
The Bottom Line
Annuities can be a useful place to invest some money if you’ve exhausted all other tax-deferred retirement plan options. But in many cases, you might be better off buying a low-fee mutual fund in a taxable account.
There are numerous insurance companies out there feeding off the uneducated investor by collecting excessive fees. If you’re invested in an annuity that’s charging you annual expenses of 2% or more, it may be time to drop that dog if you can get out without a punishing surrender fee.
Despite all the bad press annuities have gotten due to misleading sales techniques and inadequate disclosure, there are some worthy products on the market. They are commission-free, have low expenses and no surrender charges, and offer good investment choices.
If you have your heart set on an annuity, shop around until you find the right product at the right price.