If you are like some of my clients and friends, you have seen some cool marketing messages about great “guaranteed income” retirement annuity products. And, maybe, you also have seen a few marketing messages that talk about annuities being the spawn of the devil and that nobody should ever own an annuity.
So why would anybody even consider an annuity? Well, regular readers of this blog won’t be surprised that I think neither of those messages are what they seem. One of my core financial planning philosophies is that there is no one correct solution for any problem.
Every family’s financial situation is unique. There may be instances when annuities could be a great solution for some of your money for a certain period of time. Other times, annuities may create more problems than they solve.
How does an annuity work?
- An annuity is a contract with an insurance company. The details of the contract matter, so make sure you read the fine print.
- Some annuities are designed to have seemingly cool features that sound great but can be very confusing to understand. Always seek independent advice to be sure you understand what you are buying.
- In general, a traditional annuity is a single premium, fix annuity. You pay the insurance company one payment in exchange for a contractual promise to send you checks in the future. If you make a single payment and the checks you receive start next month, that’s a single premium immediate annuity. If the payments remain the same, that’s based on a fixed rate of interest, so that’s a fixed annuity. Once you buy the contract, your money is gone and all you have is the promise of the future payments. That’s why the quality and track record of the annuity company matters.
- In order for the annuity company to stay in business, they need to generate more income from the annuity premium payments in than they spend on the annuity benefit payments Remember, this is a business for them.
- If you live longer than average, you will receive more money from the annuity company than average. The longer you live the better the deal for you. And vice versa: If you die prematurely, often you receive benefits that are less than the premiums you paid.
- Generally, these things are true:
- Over a typical 10-year period, stocks have created more total return than bonds.
- Annuity benefit payments are based on bond returns.
What is a Deferred Variable Annuity and Why Would I Want One?
A variation on the traditional annuity is the deferred, variable annuity. In this case, you add money to the contract one or more times. All the deposits go into subaccounts, which are like mutual funds that are held inside the insurance contract. This approach allows you to hold a mix of stock and bonds. By changing this mix you get the chance for better returns than the fixed interest payments of a traditional annuity.
A deferred annuity means that you make the deposits then wait, or defer, to start distributions to you. Annuities can accumulate dividends and interest on the sub-accounts without creating tax. In some cases, this can be a really good deal. You can help you control your taxes and benefit from compounded growth of the money you would have paid in tax.
How Does Interest Accumulate in a Deferred Annuity?
Here again, it depends on the specific annuity contract you own. Generally, you own sub-accounts that give you a mix of stocks and bonds. Over the course of time, that stocks grow in value. Some of the stocks pay dividends and the bonds pay interest. All of this accumulates inside the account. There is no tax due on any growth, dividends or interest, until you make a distribution.
Are Annuity Withdrawals Taxed as Ordinary Income?
One of the benefits of a deferred annuity is that investments grow without tax. This is great, but when it’s time to spend the money, you will pay income tax on all the growth. If you funded the annuity with after-tax money, you get to remove all the money you deposited without tax, but when you take a distribution, the IRS assumes that all your growth comes out first and your deposits come out last.
Are There Required Minimum Distributions for Annuities?
If the annuity is funded with after-tax money (a non-tax-qualified annuity), there is no requirement for retirement distributions. If the annuity was purchased with pre-tax money (inside an IRA)(a tax-qualified annuity) then that annuity is subject to the same distribution rules as any IRA money.
Can I Borrow Money From My Retirement Annuity?
All annuities are assumed to be retirement vehicles. If you take money out of an annuity that you own, it’s considered a distribution and not a loan. If you set up the annuity with your own money, either pre-tax money in an IRA or after tax money, any distribution from a deferred annuity prior to age 59.5 is subject to an IRS penalty of 10% plus income tax on all the growth in the distribution. Immediate annuities are not subject to the penalty at any age since the purpose of the contract is to provide income immediately and distributions are expected to continue.
Some employer-sponsored retirement plans include an annuity component. Often this would be called a pension. A pension is a promise to send you a stated amount of income each month for a state period of time. It’s another kind of contract.
If your retirement plan has a pension, generally you can’t borrow from that.
Are Annuities Expensive?
Annuities are famous for the expenses, (often more than 2% per year removed from the account) so here is a breakdown on the cost of a deferred annuity:
- Commission. Most annuities are sold on commission. The sales person gets a percentage of your deposit to reward them for your purchase. Usually, the contract has a Contingent Deferred Sales Charge (CDSC) (also known as a Surrender Charge) in case you decide the sell out of the contract early. If the salesman got a five percent commission, you likely have a five-year surrender schedule.
- Sell out in year one and lose five percent off the top.
- Year two is four percent.
- And so on until at the start of year six, you can sell out without a penalty.
- Underwriting. These fees are insurance fees associated with the contract.
- If there is a death benefit, you will have a mortality expense.
- If there are other guarantees, each one has it’s own separate charge.
- Fund Expenses. Remember that the investments inside the annuity are held in subaccounts. Those investments are managed by mutual fund companies, so each account has expenses like the mutual fund sister to that fund. These expenses range from 0.5% to 1.0%.
What is the Tax on an Inherited Annuity?
If your beneficiaries inherit your annuity, they are subject to that same tax rules a you. This is a particular disadvantage compared to taxable brokerage accounts. Today, when you die and leave a taxable investment account to an heir, the heir receives a “stepped-up basis” on the investments in the account. That is, the cost basis of each investment is adjusted to reflect its market value at the time of death of the original owner. If the heir sells the investment at the same value as the value on the day they inherited it, they owe NO TAX.
What is the Primary Reason to Buy an Annuity?
You may want to consider annuities if the following are true:
- You do not want to leave money to your kids, grandkids or charities.
- You are really worried about covering your basic retirement living expenses. If you feel stress and anxiety about where the retirement income will come from, you might want the security of a contractual guarantee found in an annuity.
- You are healthy and you come from a long-lived family. If you live longer than most people your age, you get more from an annuity.
Some other points to consider when deciding whether annuities are right for your situation:
- You will likely be retired a long time, as long as 50 years. Therefore, some of your money will need to grow to keep ahead of inflation over the long term. So a fixed annuity probably won’t keep up with inflation.
- The first 10 years of retirement can be a big adjustment and can set the tone for the remainder of your retired life. Purchasing a guarantee for a portion of that transition period can be helpful for some people.
- Assume that you will monitor your retirement game plan and adjust as needed. You may find the need to become more conservative in response to your specific life events, or you might be fortunate and choose to become more aggressive to take advantage of opportunities. These adjustments might call for adding or removing an annuity over the course of your retirement.
Getting good investment advice
Many times, the most interesting and exciting message you see about annuities—or any investment vehicle for that matter—will be an advertisement for some product. Remember that the advertisement costs money to produce and costs money to put in front of you. If you see the cool message a lot, somebody is spending a lot of money to get the word out. This spending only makes sense if they have a reasonable expectation of more money coming into their company from profits they make on the product than they are spending on the ads.
So, what big ads are really telling you is that the product is pretty profitable for the manufacturer. This does not necessarily mean that it’s bad for the customer. But it absolutely means that it’s good for the manufacturer. The burden is then on the buyer to really understand what they get for their money.
Maybe I sound like a broken record, but this is an outstanding place for a CERTIFIED FINANCIAL PLANNER™ professional, fee-only, fiduciary financial advisor. CFP® professionals receive holistic financial planning training, have the fiduciary commitment to be a client advocate at all times, and have a fee-only structure. Therefore, you know you are working with somebody who is trained to understand annuities, committed to your best interests and only paid by you.
Having said all this, you should be skeptical of annuities. But you should also understand their benefits. If you would like to talk with me about how annuities fit in your situation, follow this LINK.
As I said above, every family situation is unique. If you want help understanding how an annuity could help you reach your retirement goals, you might want the help of a CERTIFIED FINANCIAL PLANNER™ professional
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 only paid by clients, not any 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-only, 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 only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
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.