In this column I’ll like to explain the fundamentals of annuities. I’ll compare the pros and the cons of annuities. You’ll see why I believe you should not consider annuities until you’ve exhausted other long-term investing vehicles such as individual retirement accounts (IRAs) and/or employer sponsored retirement plans 401(k)s, 403(b)s, 457s, etc). (I’ll refer to both individual retirement accounts and company sponsored retirement plans throughout this report as qualified retirement plans.)
Annuities are an aggressively marketed financial product. Why? There’s a nice commission check to be earned. There are two types of annuities—fixed annuities and variable annuities. With a fixed annuity the insurance company guarantees the premium paid (principal) and a minimum rate of interest. A fixed annuity is comparable to saving money inside of a certificate of deposit or money market account. With a variable annuity the insurance company guarantees the premium paid (principal). However, the earnings on a variable annuity vary because a variable annuity changes with the annuitant investment performance. A variable annuity is comparable to saving money inside of mutual funds. Annuities can be classified as immediate or deferred. An immediate annuity is one in which the first benefit payment begins immediately—one payment interval after the date the annuity is purchased. A deferred annuity is one in which the first benefit payment begins more than one year after the annuity is purchased. Immediate annuities are purchased with a lump sum. You can purchase a deferred annuity by making periodic payments or with a lump sum.
Advantages of annuities are as follows:
•Earning inside the annuity grows tax deferred.
•Guarantees income for life or two lives, or for a certain number of years.
•No contribution limit.
•No income restrictions.
•Ability to switch investments within your contract without incurring a tax bill.
Disadvantages of annuities are as follows:
•Fees, fees, fees. Mortality and expense fees, management fees and surrender fees. These fees are what allows insurance companies to guarantee that you will get back the principal you paid despite what the market does. However, the fees cut deeply into returns.
•Annuities are purchased with after-tax dollars. Upon receiving periodic payments, annuities are taxed at ordinary tax rates as opposed to lower capital gain rates.
•Depending on the terms of the annuity contract upon death of the annuitant, the insurance company keeps the earnings and in some cases the remaining principal inside the annuity.
The good thing about annuities is the fact that the pros outweigh the cons. The primary reason why I believe that you should max out contributions to qualified retirement plans before considering annuities is because many of the advantages that exist within a annuity contract also exist within qualified retirement plans. Secondly, qualified retirement plans score better on the disadvantage side.
•Fees, fees and fees. You’ll always pay more in fees with annuities than you would with a qualified retirement plan. As a result, assuming that money is saved in similar assets classes within a qualified retirement plan and an annuity, money saved inside of a qualified retirement plan will outperform money saved inside of an annuity contract.
•Annuities are purchased with after-tax dollars. With qualified retirement plans you have the option to invest before tax dollars or after-tax dollars. Investing before tax dollars with a qualified retirement plan may allow you to benefit from tax deductions. With qualified plans, specifically Roth IRAs and Roth 401(k)s investing after-tax dollars allows you tax-free distributions. You don’t get these options with annuities.
•Upon death of the annuitant, the insurance company keeps the earnings and in some cases the principal invested. Call me selfish, but this is the part of annuities that I hate the most. Insurance companies are able to guarantee payments for life or a set period of time because of the annuitant willingness to allow the insurance company to keep the earnings and in some cases the principal, should the annuitant die prematurely. Whereas with a qualified retirement plan, should you die prematurely, the entire balance of your nest egg will pass on to your designated beneficiaries or your estate. To be fair, the downside of a qualified retirement plan is that you may outlive your nest egg. This problem can be easily fixed by learning how to select the correct withdrawal rate from your retirement savings.
Like annuities, qualified retirement plans can avoid probate, offer you the ability to switch investments without incurring a tax bill. The no contribution limits and no income restrictions that annuities offer are mute benefits, given the fact that very few max out their contribution and very few earn more the limits set forth on qualified retirement plans. Should you use annuities inside your qualified retirement plan? NO! The reason is simple. One of the primary benefits of an annuity is tax deferral. Why pay an extra fee for tax deferral when you’re already receiving tax deferral from your qualified retirement plan?
I would only consider annuities in two instances. 1. After I’ve maxed out my contribution to all of the available qualified retirement plans. 2. During my retirement years, I may consider withdrawing money from my qualified retirement plan to purchase an immediate annuity.
(Mortgage and Money Coach Damon Carr is the owner of ACE Financial. Sign up for Damon’s free “Ask Damon” e-Newsletter @ www.allcreditexperts.com. He can be reached at 412-856-1183.)
Digital Daily Signup
Sign up now for the New Pittsburgh Courier Digital Daily newsletter!
- Time to share the ‘truth’ about ‘timeshares’ (5)
- Community outraged over toddler’s shooting death, Rayco declares 'War' (1)
- Protecting Black Americans’ right to compete (2)
- Sergio Garcia will pay dearly for Tiger remarks (1)
- Detroit's emergency manager takes on critics in candid interview about city’s future (1)