Money Maven: The evils of annuities

By Sheryl Rowling

Sheryl Rowling

Dear Money Maven,

I’m hearing a lot about annuities lately.  Should I consider buying an annuity?
Confused
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Dear Confused,

Since the economic downturn, annuities are being touted morethan ever as a magical protection against investment losses.

Here’swhat I say about annuities:  Ninetypercent of the people who buy an annuity don’t understand what they’re buying, and, ninety percent of the people who buy an annuity shouldn’t!  In this column, I’ll try to expose the evils of annuities.

First, an annuity is an insurance contract – the investor gives the insurance company money and the company promises to pay a stream of payments starting now (an immediate annuity) or in the future (a deferred annuity).  With most immediate annuities, the monthly payment will be paid for the rest of the investor’s life (or a fixed period of years).  With most deferred annuities, the
ultimate payout depends on how the annuity’s investments have performed.

If you are savvy enough to ask questions before signing the dotted line, you can counter the salesman’s various pitches as follows:

“Your investment is insured against loss.” The annuity has built-in insurance that will pay your heirs what you originally put into the contract if you die before taking out your money.  Truth is, this insurance is practically worthless (because over time your investments should certainly be worth at least what you put in!) and it’s expensive.

“Your money will be there when you need it.” Ask the salesman about surrender charges.  The annuity that he’s selling will penalize you for pulling your own money out early.  The penalties can be as much as seven to ten percent and “early” can
mean anything less than seven to ten years!

“You don’t pay me any commission.” Sure you do – indirectly!  The insurance company will pay your salesman three to eight% of what you put in.  Of course, the insurance company has to be paid back somehow; they get repaid through surrender charges and high fees.

“Your money is safe.”
Your money is only as safe as the insurance company issuing the annuity and the annuity’s underlying investments.

“You’ll get big tax savings.” It’s true that you don’t pay tax on income earned inside the annuity.  However, as soon as you start taking money out, you’ll pay taxes – at the highest rates.  The income portion of each payment you receive will be taxed as ordinary income.  Outside of an annuity, you could get capital gains rates. Unfortunately, in an annuity, all of your gains come out as
ordinary income.  Also, investments held outside an annuity pass to your heirs income tax-free (stepped-up to fair market value).  With an annuity, your heirs pay tax at ordinary income rates on the entire gain.

“The annuity offers superior investment options.” With most annuities, your investment options are extremely limited.  You’ll be stuck with choosing from a few “captive” high-cost mutual funds.

In addition to dispelling the usual arguments, be sure to educate yourself on a few other points.

Just because someone manning a desk in a bank’s office recommends an annuity does not mean the bank is recommending an annuity.  That person is earning a commission and the principal is not FDIC insured.

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An annuity should not be purchased within a tax-deferred account, such as an IRA.  There is no benefit to paying the extra costs
and fees of a tax-deferred annuity when the IRA is already tax-deferred.
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Investors should beware of their insurance person’s recommendation to roll an old annuity into a new one.  They might incur a surrender charge and can start the clock ticking on a new surrender charge.

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On the other hand, there may be a few occasions when an annuity might be appropriate:

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It might be appropriate to roll a previously purchased high cost annuity into a no-load annuity – assuming most or all of the surrender charges have expired.

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If you have exhausted allother means of tax-deferred savings, the money won’t be needed right away, and your tax bracket might be lower in the future, a low cost deferred annuity might be worth considering.

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If you are older and have a need for a guaranteed income stream for life, an immediate annuity might be appropriate.

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Sheryl L. Rowling, CPA/PFS, partner of Moss Adams Wealth Advisors LLC, has been providing tax, financial planning and investment advice for over 30 years, since 1979.  She may be contacted at sheryl.rowling@sdjewishworld.com