I was talking with a client recently and the subject of annuities came up. They said that they had heard that, “you should stay away from annuities.” So, I mentioned that, like most everything in financial planning, staying away from annuities depends on your situation.
Let’s take a look at annuities and where they fit in an overall investment plan.
First, what’s an annuity anyway?
The term annuity refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments. The holding institution issues a stream of payments in the future for a specified period of time or for the remainder of the annuitant's life.
What is a fixed versus variable annuity?
Annuities are an account that accepts deposits, then makes payments later. The deposits can be invested in fixed-interest instruments, like bonds, or the deposits can own stocks.
- Fixed annuities are much like a CD at your bank.
- When you open up the contract you get a known rate of return. Usually for the life of the annuity contract.
- Your return is guaranteed by the issuer and will not vary. No downside risk. No chance you will do better than the published rate.
- Variable annuities are much like an investment account.
- You own various investment funds that own stocks.
- You will get the market returns of the stocks you own.
- You get the possibility of loss and the chance of better returns.
What’s a fixed-indexed annuity?
An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P 500. It differs from fixed annuities, which pay a fixed rate of interest, and variable annuities, which base their interest rate on a portfolio of securities chosen by the annuity owner. Indexed annuities are sometimes referred to as equity-indexed or fixed-indexed annuities.
- An indexed annuity pays a rate of interest based on a particular market index, such as the S&P 500.
- Indexed annuities give buyers an opportunity to benefit when the financial markets perform well, unlike fixed annuities, which pay a set interest rate regardless.
- However, certain provisions in these contracts can limit the potential upside to only a portion of the market's rise.
How are annuities given favorable tax treatment?
The key tax benefit of annuities is the deferral of tax payments. When you make a deposit to an annuity, any growth, dividends, or interest is not taxed until you take it out. This allows the dividend and interest to compound without the “drag” of paying taxes every year. In exchange for the benefit of tax deferral, you must pay tax on annuity distributions as regular income.
In traditional taxable investment accounts dividends and interest are reported each year and you pay tax at the current dividend rate for dividends and at regular income tax rates for interest. Growth in the value of your investment is only taxed when shares are sold. This creates a Capital Gain that is taxed at special rates.
For comparison, here are the rates for Income, Dividends and Capital Gains:
Federal Income Tax Rates 2021
So, Are Annuities a Good Idea?
Of course, it depends.
- Good -- One place an annuity can be great is to provide predictability. When you buy a fixed annuity, you know what the return will be. You know how much you will receive each month in income. There are no surprises.
- Bad -- The problem is that fixed annuities base their rates on US Treasury rates which are at historic lows. As I write this a 30-year Treasury bill pays 1.965% interest for 30 years. Inflation has averaged 3% over the last 50 years and is likely to be higher than that in the next few years, so money invested in an annuity that pays 2% will not keep pace with inflation.
- Good – You own stocks in a tax-deferred wrapper. You pay no tax on dividends or interest.
- Good – Stocks have historically grown faster than the rate of inflation. The average rate of return on the S&P 500 (the 500 largest U.S. companies) over the last 100 years has been 84% per year with dividends reinvested.
- Good – Annuities offer contractual guarantees of income that can provide for more income over your life. If you live longer than expected, contractual guarantees can deliver substantially more income to you over your life than a plain investment account.
- Bad – Many of the guaranteed options are really complex. They are often designed by marketing experts, so they sound fabulous. Sometimes, they can be quite expensive -- as much as 2% to 3% of the account value per year.
- Bad – Growth in your stocks will be taxed when you remove it from the contract. That tax rate will be your personal income tax rate at that time. Based on current tax you’re your personal income tax rate is higher than the rate for Capital Gains on the same stocks in a taxable account.
So, clearly, you will want some advice about how an annuity might help you reach your goals. That advice will be better if it comes from somebody with great training, lots of experience and a commitment to acting as your advocate as a financial planning fiduciary.
If you would like to talk with me about annuities and your financial goals. I would be honored to have a chat. Follow this LINK to find a time that works for you.
A great place to start looking for that advice is to talk with a couple CERTIFIED FINANCIAL PLANNER™ professionals.
To find a CFP® professional near you, start your search here.
As you visit with financial planners, I suggest a couple things to check:
- Is the advisor always the client’s advocate – a fiduciary advisor?
- Is the advisor paid by clients, not financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed to your best interest at all times. It seems sort of obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-first, CFP® professional can help you make great retirement income choices and develop a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
Fixed annuities are designed to meet long-term needs for retirement income. Early withdrawals may result in loss of principal and credited interest due to surrender charges. Distributions may be subject to ordinary income tax and, if taken prior to age 59 ½, an additional 10% federal tax. Prior to purchase you will want to read and understand the contract details and consult with professional in this area.
Investors should carefully consider the investment objectives, risks, charges and expenses of variable annuities and the underlying funds before investing. This and other information can be found in the prospectus for the variable annuity and the prospectuses for the underlying funds. Please read them carefully before you invest.
Fixed index annuities are designed to meet long-term needs for retirement income. Early withdrawals may result in loss of principal and credited interest due to surrender charges. Distributions may be subject to ordinary income tax and, if taken prior to age 59 ½, an additional 10% federal tax. An income rider or benefit (sometimes called Guaranteed Lifetime Withdrawal Benefits, or GLWB) is an additional feature available with some annuities and generally optional and come with additional cost. Income benefits are designed to provide income options above and beyond the standard annuitization or free withdrawal features in annuities.
Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company.
If this article has you thinking about your own circumstances, contact my office at firstname.lastname@example.org. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.