An annuity is a contract between insurance companies and people arranging for retirement.Â The insurance company agrees to pay you money in the future for the money you give them now.Â In theory, an annuity would make sense because:
- Annuities offer guaranteed income in the future (although surprisingly, the definition of guaranteed is malleable here).
- Annuities are tax deferred retirement investments.Â You pay taxes first for money you put into an annuity.Â The capital gains grow tax-free until you start withdrawing them.Â When you receive your annuity benefits, you will pay taxes on capital gains as well.
So far, annuities sound good.Â The following problems, however, exist with annuities:
- Annuities lock up money for a minimum period (usually five years).Â If you want your money, you will need to pay surrender fees.Â Surrender fees are stiff.Â They range anywhere from 5% to 7%.Â This is in addition to the federal 10% early withdrawal tax.Â This tax occurs when money is taken of retirement funds before the owner is 59 Â½ years old.
- Annuities often offer lower returns than other retirement options.
- Contributions are not pre-tax as they are for 401ks.Â The earnings are, however, tax deferred.
- The IRS taxes capital gains earned in an annuity as ordinary income.Â Ordinary income taxation rates are higher capital gains rates.
- Annuities usually have many more fees than other retirement options.
- Annuities are not the best for estate planning.Â If you die before using your annuity, beneficiaries must pay taxes on the capital gains.Â Not so with mutual funds.
Why consider an annuity at all?Â Annuities make sense in the following situations:
- You have maxed out 401k and IRA annual contributions.Â You still want to invest money into tax deferred investment options.
- Annuities do not have a contribution limit.
- You want to diversity your retirement plan.Â Insurance sounds wonderful to pessimists.
When shopping for annuities, one size does not fit all.Â Types of annuities include:
- Fixed annuity meaning the interest rate for the invested money is fixed.Â It does not change.Â The money is usually invested in low-risk fixed income products like bonds.
- Variable annuity meaning the interest rate for the invested money is variable.Â This type of annuity can produce a higher or lower payout.Â The payout depends on how well the investments do.Â Variable annuities usually still have guaranteed minimum returns.
- The equity-indexed annuity is an option that has been around for about ten years.Â This annuity acts a variable annuity with a safety net when the market gets bad.
Payout schedule options include immediate payments and deferred payments.Â Payments can last for the ownerâ€™s lifetime or for a set term.Â Other options when purchasing annuities include:
- Cost of living protection
- Premium protection
- Joint and survivor benefits
Annuities are only as good as the insurance company backing them.Â Shop around before picking one.Â Do not buy in a rash moment.Â Make sure you know whom you are dealing with.
Federal law allows for tax-free exchanges between annuities.Â This can happen if you decide you invested your money in a poor annuity.Â You would like to move your money to a different annuity.Â Normally, if you take money out of an annuity before retirement, you face the 10% early distribution penalty tax.Â However, if you move the money into another annuity, US tax code 1035 allows for tax-free exchanges.