What to consider before Purchasing an Annuity

Annuities are a financial planning tool that come in a variety of types and strategies, designed to maximize distribution of funds in a tax advantaged manner. It is probably one of the least understood and poorly implemented tools in planning and in many cases sold to the wrong people.

There are two types of annuities- Deferred Annuities and Immediate Annuities. Annuities provide tax deferred growth of money deposited, a guaranteed death benefit, and a death benefit that often passes to the beneficiary on a tax advantaged and probate free basis.

Deferred Annuity- This is where the annuitant places in money in trust (typically with an insurance company) for a future date of withdrawal. During this phase of the annuity, the money accumulates at either a fixed rate of return or a variable rate of return. Fixed annuity rates vary from company to company, with higher rates usually paid by smaller or higher risk institutions or companies aggressively seeking new business. Also higher rate paying annuities come often with higher early withdrawal or surrender rates. The money in an annuity during the deferred or ‘accumulation’ phase, grows on a tax-deferred basis- this means you don’t pay tax until you withdraw the money.

Immediate Annuity- This is where the annuitant places money in trust with a company and the company distributes a portion immediately back to the annuitant over a period of years or until death. The money coming out of an immediate annuity is distributed on a tax-advantaged basis, which is the primary reason why immediate annuities are attractive to retirees looking to withdraw money from savings rather than CD’s.

Here’s an example. A retiree places $100,000 in a bank CD earning 10%, withdrawing the interest annually. When the retiree receives the 10k, 100% of the money is taxable- if the retiree is in a 15% income tax bracket, this results in a $1500 tax bill. If this same retiree placed the amount in an immediate annuity- lets say earning that same 10%- and was on a schedule for that same 10k a year, only a small percentage of that amount would be taxable, since the IRS considers annuity distributions as a partial return of principal. The taxable amount is determined by a IRS formula based on age and rate of return- the insurance company will provide a table to let you know the total taxable gain- BUT MOST CERTAINLY BE SUBSTANTIALLY LOWER THAN THE CD TAXABLE GAIN.

Both immediate and deferred annuities come typically in two flavors- fixed and variable. A fixed annuity is where you get a guaranteed rate of return determined at the time of deposit, where a variable annuity is based on the performance of the underlying funds you choose. Variable annuities typically have an internal fee structure which reduces the true performance of the underlying funds. It is for this reason that many people shy away from variable annuities, since as the investor you assume the risk of the choice of funds, but do not receive the full benefit of the returns. Also, many VA’s (variable annuities) have high internal fees relative to the benefits of the policy- sometimes in excess of 2%. Read the fine print carefully before considering a VA since ultimately, due to the fee structure and variable performance of the product, you may receive LOWER returns than a typical fixed annuity.

Annuities are really designed for the PAYOUT end of financial planning and more often than not they are overused as ACCUMULATION tools (which they are relatively poor at). When planning your retirement there are many strategies which can greatly affect your overall income if used properly (including deferred compensation and split-dollar annuities) and should be considered in any good retirement income strategy.

Dangers to look for- Watch out in fixed annuities for long surrender charge periods, withdrawal fee structures or extensive rules and restrictions on withdrawals. These are where companies can really rack of the fees reducing your overall income. Often unscrupulous companies with offer attractive interest rates with boldface type in order to sell you annuities with high fee structures. With VA’s you have to be careful of high internal fees, policy fees or anything that reduces your overall rate of return.

In particular beware of ‘indexed’ annuities. Many indexed annuities have rules and fees which make it difficult to withdraw money and in some cases make it almost impossible to withdraw your deposit fully- some with annuitization structures designed to lock up your money well past your retirement years.

Consult with professional adviser, or planner, or agent and read the fine print before making any purchase.

Good Luck!