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Are Annuities Right for You?
Annuities are not complicated, which is why so many people find them appealing. They come in two basic types — immediate and deferred — with two ways of calculating earnings — fixed and variable.
- Immediate annuities: As their name implies, these begin paying you as soon as you buy them. Payments are based on your original investment plus earnings spread over a certain number of payments or period of time, ranging from five to 20 years. They can also be set to make regular payments for the remainder of your life. The rate of return of these annuities is calculated based on your sex and age at the time of purchase.
- Deferred annuities: Unlike immediate annuities, these can be purchased anywhere from months to years before you wish to start receiving payments. Since they do not begin making payments immediately, contributions can be made in either a lump sum or in regular monthly or annual payments.
- Fixed annuities: This refers to the way payments are made and interest is calculated. It means the interest or earnings rate is guaranteed and the amount of each payment is fixed. The rate of return is usually guaranteed in increments of three to 15 years. Insurance companies are able to guarantee earnings because they typically invest in government or corporate bonds with guaranteed rates of interest.
- Variable annuities: The rate of earnings and the amount of payments will vary depending upon the performance of their investment portfolios. These annuities usually have a guaranteed minimum payment.
Annuities are unlike other investments in that their interest and earnings accumulate on a tax-deferred basis. That gives annuities an advantage over things like bank CDs or dividend-paying stocks whose interest and earnings must be reported on each year’s income tax return.
The tax savings can be substantial, especially in the case of an annuity that defers payments until after retirement — when your income and tax rate are lower. Single-payment deferred annuities also provide a means of putting aside additional tax-deferred funds for retirement after annual IRA contributions have been reached.
Insurance sales managers regularly tell agents that annuities are not bought, they are sold. The root of that axiom comes from the fact that annuities are not viewed in a positive light by most insurance and investment advisors. They are largely viewed as better for the insurance company than they are for the consumer.
The biggest negative for many annuities is that, in the event of the death of the annuity’s owner, the undistributed proceeds — both principal and interest — revert to the insurance company. So it’s possible to buy a $50,000 immediate annuity one month, collect two payments before passing away, and your estate will not be entitled to any of the unpaid balance.
Some annuities allow you to name a beneficiary who will receive the remaining proceeds, but there are problems with that as well. The first is that your beneficiary is bound by the same terms as you originally agreed to. The second is that when your beneficiary dies, the remaining balance is lost. This is particularly important if the annuity is intended to be used in retirement, the beneficiary is a spouse, and the ages of both the recipient and beneficiary limit the likelihood of a full distribution.
Speaking of beneficiaries, in cases where a beneficiary is allowed, the tax advantages of the annuity fall by the wayside. This is because inherited annuities are treated as a tax disadvantage when compared to other inheritable assets like stocks and bonds or real estate.
The difference is that the cost basis of annuities is not passed on to your heirs. That means they are taxed not only on the interest earned, but on the principal as well. This is true even if they will not receive the proceeds for many years to come.
Unlike other investments, annuities are not completely transparent when it comes to commissions, which can be substantial. Commissions can have an effect on the rate of return paid by the insurer because they are deducted from earnings before they are distributed to you. Commissions and other administrative costs are often hidden by rolling them into the mortality and expense charges and can vary from one annuity to another, even from the same insurance company.
Finally, if you decide to cash out your annuity rather than wait for its distribution, you will be subject to a surrender charge that is based on a percentage of the annuity’s value.