Questions to ask before Buying an Annuity

There are a lot of financial products which receive some negative attention, such as gold and whole-life insurance, however if there was one investment product which consistently received bad news, it would have to be the variable annuity. We often hear about dishonest brokers who push people into high fee annuity plans without explanation. Should we avoid them at all times though? Are there any cases where an annuity makes sense? Let’s find out.

First, let’s explain just what a variable annuity is. Essentially it’s a contract between you and an insurance company. In return for your lump sum of money, the insurance company will provide you a stream of income at some future date. Quite often newer annuity plans will also offer a death benefit and additional withdrawal options. When you withdraw money from annuity, you will have to pay your normal income tax rate, and if you are under age 59 and a half, you will have to pay another 10% penalty! Inside the annuity, the money is invested in some sort of investment, such as a mutual fund. If the mutual fund and the economy do well, they might increase the amount of money you get annually.

Are there any advantages? It turns out there are a few. The biggest advantage is that you can invest money tax deferred with out yearly limits much in the way you can with 401k or IRAs. In all cases it makes sense to shelter your money with a 401k first or an IRA before you consider an annuity, because you can invest in mutual funds just like you can with your annuity, but you can avoid all of the fees. The second advantage is that you are guaranteed to not lose any money, regardless of what happens to the stock market. This might be something which attracts those who have a very low risk tolerance.

Variable annuities also have numerous disadvantages. They generate very high commissions for the broker, so they are often pushed on people who really should not have them. They also have much higher fee structures than other investments, such as mutual funds. Usually these fees can be upwards of 2% or 4% of your annual return. On top of that, there are generally huge surrender fees in annuities which average to be about 7%.

So what’s the verdict? In most cases an annuity does not make sense. If you have fully funded your IRAs and 401K plans with good mutual funds, and are looking for other tax deferred investments, an annuity might be the way to go. Be sure to find one with low fees and without a surrender charge.