Having maxed out your annual contributions to your 401(k), IRA, or other tax-deferred investment vehicle, you are now considering purchasing a variable annuity. Think long and hard about it. Not all annuities are created equal. 

Most people think of annuities simply as a steady income stream or something associated with winning your state lottery. Before you purchase one, you need to consider all the benefits and shortfalls to determine if an annuity is a good product for you.

Key Takeaways

  • A variable annuity provides you with a regular, set income for life, but if you die before the money with which you purchased it is all paid out, the remaining portion goes to the annuity, not to your heirs.
  • If you take funds from an annuity prior to age 59½, you must pay a 10% tax penalty.
  • Due to subaccounts with a number of mutual funds, it’s easy to change investment direction with a variable annuity.
  • Variable annuities often carry considerable fees, some of which are hard to spot, so always check the fine print.

What Exactly Is a Variable Annuity?

The two broad categories of annuities are immediate and deferred annuities. With an immediate annuity, you make a lump-sum deposit, and the insurance company guarantees an immediate monthly payment until your death. The monthly amount is based on your life expectancy. This is the type of payout option that most states offer for lottery winnings.

With a deferred annuity, you invest your money and watch it grow tax deferred, as the name says, until you decide to take out your money. A tax-deferred annuity can have a fixed rate, or it can be a variable-rate product. It is this increasingly popular variable type—with subaccounts that allocate your money among mutual funds—that we will investigate here.

Variable annuities are commonly called “mutual funds with an insurance wrapper.” In an all-in-one package sold by an insurance company, a variable annuity combines the characteristics of a fixed annuity with the benefits of owning stock or bond funds. Investors pay a premium to the insurance company, which then buys accumulation units under the investor’s name.

The Good

Annuity ownership can have benefits, such as the following:

  • Tax deferral of investment gains: Just as in an IRA, your contributions and earnings can grow tax deferred until you start to withdraw funds.
  • Ease of changing investments: Because variable annuities have subaccounts with various mutual funds from which to select, it’s easy to change investment direction at little or no cost.
  • Income for life: Once you annuitize your contract, which means selecting your regular payment, the insurance company will guarantee you (and your spouse, should you desire) the income payment for the rest of your life.
  • Asset protection: In certain states annuities are a shelter from creditors and lawsuit plaintiffs. If you work in an economically hazardous occupation—or one often subject to malpractice—they may be a great savings tool.

If you wish to swap your annuity for one from another company, you could end up paying a hefty surrender fee depending on when you want to do it.

The Bad

Although the idea of income for life sounds great, there is one huge pitfall that most annuity sales reps forget to mention. Once you annuitize your contract, your decision is final. The terms are frozen.

Let’s look at an example. Say you put $264,000 into an annuity at age 60 and accept the insurance company’s offer to pay you $1,000 per month for the rest of your life. You will have to live until age 82 to break even on the contract. If you live past age 82, the insurance company must continue to send you the monthly check, but if you die before you reach age 82, the insurance company keeps the remaining funds.

So even if you die as early as age 63, the insurance company retains the balance of your $264,000. Many investors find this hard to swallow. Nevertheless, prior to selecting payout, they have to decide whether annuitizing will be beneficial. Ultimately, this depends on how long they think they will live.

Another downside is that once you put funds into an annuity contract, you cannot touch those funds until you reach age 59½, or you pay a 10% penalty to Uncle Sam. When you do start to take funds from the contract, the portion of your payments that is considered investment gains is taxed at your ordinary income tax rate instead of the long-term capital gains rate. For many, this rate could be higher than the current capital gains tax rate.

So you think that it can’t get any worse than your funds being frozen once you select a payout option? Guess again.

The Ugly

  • 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) starting somewhere around 8% in the first year down to 0% in year eight. So a $200,000 investment could cost you $14,000 (7%) in surrender fees if you exchange your annuity for another company’s in the second year.
  • Front-end loaded annuities: Annuities are still primarily commission-based products. When your salesperson attempts to sell you the annuity contract, don’t be afraid to ask about the commission they collect. You can bet that if the agent is making a 5% commission on the sale, your funds will be under surrender penalty for at least five years. The mutual funds in the subaccounts will charge fees, too, so check for front-load fees, 12b-1 fees, and others.
  • Annual fees and administrative/mortality and expense charges: This is the area where investors often get burned. These charges are buried in the cost of your annuity contract and take away from your annual profits. The average annuity will charge somewhere around 1.4% for all these expenses, but some rack up fees as high as 2.5%.

The Bottom Line

The annuity in its simplest form is a contract between you and the issuing insurance company. Annuities can be a useful place to invest some money if you’ve exhausted all other tax-deferred retirement plan options, but you really need to do your homework. In many cases it may be better to buy a mutual fund outright in a taxable account.

There are numerous insurance companies out there feeding off the uneducated investor by collecting surrender charges, loads, and other excessive charges. If you’re invested in an annuity that’s charging you annual expenses of 2% or greater, it may be time to drop that dog. Don’t let yourself be one of those victims.

Despite all the bad press they’ve garnered from misleading sales techniques and inadequate disclosure, there are some worthy annuity products out there. They’re commission free, have low expenses and no surrender charges, and offer some good investments. If you have your heart set on annuity investing, shop around and find the right product at the right price. All the better to keep more of your funds where they belong: in your own wallet.