When the markets are especially volatile, you start hearing more about annuities. Annuities are contracts between investors and insurance companies. The idea of annuities is to give up money now so you can have money later. Annuities attempt to provide security at a later date in time, and are most often beneficial in providing an income for retirees. Unfortunately, the price you pay for this insurance can be steep and confusing.
Here’s how it works. You give the insurance company money as a lump-sum or in installments. Depending on the terms of your contract, the insurance company may begin to pay you back immediately or at a later date. The attraction lies in the ability to secure an income for a later date when finances are expected to be less certain—such as in retirement.
There are a few critical points to consider before jumping into annuities. First, if you withdraw money early, you may pay substantial surrender charges and tax penalties. Also, you have to be wary of promises or performance guarantees because there is not a third party, such as the U.S. government, backing their word. Any guarantees are coming from the insurance company itself. Another concern is contracts will often include unique provisions that make them less favorable. For example, they may offer short-term guarantees of higher rates only to permanently reduce your return later. It’s crucial to read the fine print carefully.
There are many different types of annuities, but they can be generally labeled as fixed, indexed or variable. Fixed annuities are probably the least complicated. In exchange for your money, the insurance company promises a fixed interest rate. Your contract determines whether these payments are paid throughout your lifetime (life contract), or for a specified amount of time (term certain contract).
In a life contract, if the owner dies before the contract expires, the remaining value may be paid to your beneficiaries. However, certain contracts will forfeit the remaining principal to the company. Again, read the fine print carefully and talk to one of our trusted investment advisors.
Equity-indexed annuities are linked to a stock index, such as the S&P 500. This allows you to benefit from increases in market value. The exciting part is you receive a minimum fixed interest rate even in years when the market loses value. Is it too good to be true? Probably.
Insurance companies have several ways to limit the interest rates they pay. There may be limits to how much you get to participate in market gains. If the market rises 60 percent, you may receive a reduced portion. It is also common to see caps on maximum annual returns. In other words, no matter how much the market increases, the insurance company may cap your annual gains at say, 10 percent. There is a good chance the promised returns are not as good as they sound.
A variable annuity (VA) may be enticing at first. Unlike an IRA or 401(k), there are no annual contribution limits to VAs. So, you can receive tax-deferred growth on larger sums. The range of investment choices include stock and bond mutual funds. VAs also include an insurance component allowing a death benefit for your beneficiaries.
One major drawback to variable annuities is incredibly high commissions to the selling agent, broker or banker. It is normal to see six to ten percent of your capital go toward commissions. The tax structure may not be as good as it seems either.
Variable annuities and taxes
The potential unlimited contribution to a tax-deferred investment is a huge selling point for variable annuities. What is often overlooked though is when you start making withdrawals your earnings are taxed as ordinary income. This is different from gains on mutual fund investments, which, depending on length of time held, may be taxed as long term capital gains. So, someone in the highest tax bracket would pay 35 percent on variable annuity proceeds while long term capital gains would have only been 15 percent. Of course, the person who wants to contribute well above the maximum limits of traditional retirement accounts is often in a higher tax bracket. While this is based on current laws, note that tax laws are subject to change with little or no notice so it is always wise to consult a tax advisor.
For many, the complexity of contracts, high commissions and expenses, lack of liquidity and potentially inferior tax treatment may outweigh the benefits of variable annuities.
What to do next
- Do your research on annuities and remember to read the fine print.
- Talk with an investment advisor to discuss the best options for your unique goals and financial situation.