For investors thinking about purchasing an annuity, there are two things they should do first. One, speak with a financial advisor (other than the one trying to sell you the annuity) so you can get an unbiased explanation of how the annuity contract works.
Second, consider these three reasons not to buy an annuity.
Most types of annuities restrict access to your principal for a certain number of years. If you have an unforeseen need for cash and have to exit the contract early, you might have to a pay a penalty to access your money.
Also, if an annuity is purchased with taxable money (non-qualified), you cannot withdraw that money until age 59 ½ without paying a 10% penalty on the taxable earnings, – in addition to other taxes you might face, which we discuss more below.1
Some annuities offer guaranteed income streams for life, which some investors find appealing. However, the catch is that often times the amount and timing of the annuity income stream cannot be changed. This lack of flexibility can be problematic when your income needs change, as is often the case during retirement.
Your annuity contract investment options are often limited and may not fall in line with what your long-term financial plan calls for. Compare this to the investment options outside of an annuity, such as money managers, separately managed accounts, mutual funds, ETFs, and so on, that make sense relative to your goals.
If you need to get more than a small amount of your money out of an annuity contract within the first couple of years, you’ll likely have to pay a surrender fee. While these fees can decrease over time, annuity surrender schedules may typically range from 7% - 10%2 (but can be even as high as 20%)3 of your money, and they may apply for 3 – 15 years depending on the type of annuity.4
Your goals and investment objectives will likely change over time and annuities can make it difficult and costly to adjust your investments with those changes.
It’s true that earnings in an annuity grow tax deferred.1 However, as a result of this tax treatment, it becomes difficult (if not impossible) to customize your tax management strategy with annuities. Since you can’t realize capital gains or losses within an annuity, you can’t use them as a tax planning tool in that regard.5 With stocks, you’re able to realize losses and differentiate between short and long-term capital gains, which can help when managing your taxes.
Annuities purchased after August 13, 1982 use a LIFO (Last In, First Out) tax method. This means that once you start taking withdrawals from the annuity, your earnings – which are taxed at ordinary income rates – will come out first.6 Once all these gains are distributed, then your principal can be withdrawn, usually tax free.
Annuities do not provide a step-up in cost basis at the time of passing, so your heirs will have to pay taxes based on the original cost of the securities in your annuity. This is different than owning individual stocks, where the cost basis can be “stepped-up” to prices at the time of passing – meaning that your heirs could have a smaller tax burden.1
For an investor with limited assets and the need for guaranteed income, an annuity could potentially make sense. But for many investors, we see few reasons to buy an annuity. We can help you determine whether an annuity you’re considering is a good idea and if it fits well into your overall financial plan.
If you want to speak with an advisor about alternatives, please call one of our Wealth Managers today at 1-800-541-7774 for a free consultation.
Sources:
2 SEC
3 About.com
4 About.com
5 Fidelity