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-- Posted: June 8, 2000

Dorothy Rosen -- The Dollar Diva 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.
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Investment options

    Fixed annuity
    Carries an interest rate that starts out as a fixed percentage and is usually adjusted annually.

    Variable Annuity
    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 expectancy

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 low fees.
  • Annuities are generally bought with after-tax dollars.
  • 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 don't need.
  • 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.

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Basics of a personal loan
Taking cash out of your home
Financial advice glossary
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