May 2017


I was watching TV recently when a commercial came on about annuities. The commercial made it out that annuities were the best things since sliced bread claiming that you could not lose money with them and they were an investment everyone should have, particularly in retirement. Like most commercials, there was some truth in it; however, the commercial did not tell the whole story. In many situations annuities are aggressively marketed and just that alone should give people cause for concern. After all, when it comes to investing, you don’t want to be sold something that doesn’t fit your situation. Therefore, I thought I would take this opportunity to talk a little bit about annuities, pros and cons.

Basically, there are three types of annuities: fixed annuities, variable annuities and immediate annuities. Fixed annuities and variable annuities have the benefit of income growing tax deferred. You only pay taxes when money is withdrawn and at that point in time it is taxed at your ordinary income bracket. Although tax deferral can be a benefit, it also can be a problem. When money comes out of an annuity it’s taxed at your ordinary income bracket-which is your highest tax rate. Annuities don’t qualify for the favorable capital gain treatment; therefore, it is possible that by deferring your taxes you are actually raising them; thus, defeating the purpose of an annuity.

The returns on annuities depend upon the type of annuity you purchase. In a traditional fixed annuity you get a guaranteed rate of return. Currently, traditional fixed annuities are paying about two percent. An index annuity is also considered a fixed annuity; however, your return is based upon an index that you select. Typically, these indexes are stock-based indexes. The nice thing about these types of annuities is that if the market goes down you don’t lose money. However, it is important to keep in mind that dividends are not figured into the equation and that most index-based annuities do not give you a 100 percent participation rate. If your participation rate is 60 percent and the market went up 10 percent, your return would be six percent.

One of the problems with index-based annuities is that they are very complex and sometimes very difficult to understand. If you end up buying an index-based annuity it is important to learn about them and then to shop around. There are tremendous differences with regard to fees on these annuities.

Variable annuities are annuities that allow you to invest in typically, mutual funds. Therefore, your return is based upon the funds you select. The problem with variable annuities is that if you held these investments outside the annuity they would be subject to capital gain treatment versus ordinary income. In addition, just like with the fixed annuities, you typically have to lock your money up for a period of time. It’s not unusual to see variable annuities with a 10-year penalty period, which means if you cancel the annuity before 10 years you lose some of your money. In addition, variable annuities tend to have very high administrative and investment fees.

An immediate annuity is a different animal all together. An immediate annuity is similar to buying a pension for yourself. In an immediate annuity they guarantee you a certain amount of money for the rest of your life. Therefore, no matter how long you live you’ll get a regular paycheck. For many people this is a very comforting investment. The downside is that once you’re in an immediate annuity you cannot cancel it. Therefore, it’s an irrevocable investment. Just like with fixed and variable annuities, it does pay to shop around. Not all companies are the same.

In certain situations annuities make sense; however, they are not for everyone and certainly no one should be pressured into purchasing one. My general advice, if a salesman is overly aggressive, simply walk away. Because annuities are generally long-term investments, you need to take your time and shop around.

One last note, if you are looking at a variable annuity you want to make sure you look at companies like Fidelity, Vanguard and Schwab. They all offer low-cost annuities without penalties. Therefore, you have greater flexibility in the fact that you can withdraw your money at any time without penalty from the annuity company.

Good luck!
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