||Ask the Dollar Diva
The pros and cons of annuities
Dear Dollar Diva,
What are some of the pros and cons of annuities?
An annuity is a life insurance contract sold by insurance
companies, brokers and other financial institutions. It is usually
sold as a retirement investment and is paid for before retirement
in exchange for lifetime payments after retirement. Before talking
about pros and cons, let's look at what they're selling.
Types of annuities
There are two types of annuities available to investors:
- Immediate annuity: You give the company a
large sum of money, and your payments start immediately. This
option would appeal to someone who is at least in his 60s.
- Tax-deferred annuity: You give the company
a large sum upfront or make monthly payments until you reach retirement
age. The money grows tax-free until you retire. This works best
for someone who has a big chunk of change to put up front and
at least 20 years for the money to grow tax-free before setting
up a schedule of lifetime payments that would start after retirement.
Carries an interest rate that starts out as a
fixed percentage and is usually adjusted annually.
The purchaser selects from a list of mutual
funds and his payments are invested in the funds he picks; future
payouts depend on the funds' performance over the years.
There are variations on these themes, such as variable
annuities that invest in index funds, but they all boil down to
income contracts or equity contracts.
When should an annuity be considered?
Only after you've contributed the maximum to your
401(k), SEP, Keogh, IRA and whatever other tax-deferred opportunities
are available to you, should you consider an annuity.
What's good about an annuity?
Assuming you're buying it with after-tax dollars,
here are some of the pros of investing in an annuity:
- Lifetime income is guaranteed
- Earnings are tax-deferred
- There is no limit on how much you can contribute
- There are no income restrictions
- You can switch investments within your contract
without paying taxes
- You get a premium for outliving your life
What's bad about an annuity?
- Fee and commissions can be high and cut deeply
into your return. Look for low-load or no-load contracts with
- Annuities are generally bought with after-tax
- At payback time, income is taxed as ordinary
income, even if most of it is from capital gains. Not good if
you're in a 28 percent or 39.6 percent income-tax bracket and
your capital gains tax rate is 20 percent.
- Annuity talk can sound like doublespeak,
making it hard to separate the good contracts from the bad ones.
- An annuity is a long-term investment, and
bailing out early can kick up penalties, taxes and surrender charges.
- You could be paying for life insurance you
- You need a long stretch of time and a big
chunk of money to make it work.
When in doubt, stick with tax friendly mutual funds.