What is an annuity and does it
belong in your IRA portfolio?
1, 2000 -- If you've ever bought a life
insurance policy directly from an agent, you probably also got a
sales pitch for an annuity. Tax-deferred annuities can be a good
way to make sure you have income during retirement -- but critics
say that, among other things, they're too expensive and that variable
annuities subject you to higher taxes than you'd pay with a mutual
fund. We'll take a look at these and other issues and also consider
whether annuities belong in your IRA portfolio.
is an annuity?
An annuity is a contract between you and an insurance company. Whether
you buy it from an agent, a brokerage or your brother-in-law --
if he's licensed to sell them -- the contract is only as good as
the insurance company that underwrites it, so make sure the company
is on solid financial ground.
In essence, you give the insurance company a
specific amount of money and the insurance company agrees to make
payments to you for a specific amount of time -- even for the rest
of your life and the life of your beneficiary. The insurance company
is betting you won't outlive the life expectancy predicted by actuarial
tables and that it can invest your money so wisely that it will
make plenty of profit off your premiums -- far more than it will
pay to you.
Laurie Lewis of the American
Council of Life Insurance in Washington, D.C., says annuities
are good for people who don't have a pension plan at work.
"People in their 20s, 30s and 40s who have
no steady stream of income beyond Social Security -- we're talking
about a stream they can't outlive. This is important, especially
as people are living longer. You can buy an annuity that won't run
out until you leave this earth and there's no extra charge."
you need to know
There are a couple of things that most experts agree on when
it comes to annuities: Max contributions to your 401(k) or employer-sponsored
retirement plan before contributing to an annuity. Even though money
in an annuity grows tax-deferred, you're paying a fee to the insurance
company. Why pay a fee for a tax-deferred account when your 401(k)
does it for free? Also, don't use an annuity for short-term money
needs. Plan on letting the money grow for at least 15 years, or
steep fees imposed by the insurance company and by the government
(if the annuity is in an IRA) will eat up your returns.
There's a lot to consider when buying an annuity.
There are many types
of annuities and payout plans.
Unlike IRAs, there's no limit to the amount
you can contribute to an annuity and there's no rule that says you
must begin withdrawing money at age 70-1/2. In addition, earnings
grow tax-deferred until you begin taking payments. However, if you
make an annuity part of your IRA portfolio it will be subject to
the same regulations governing retirement accounts. In an IRA the
money contributed might then be tax-deductible in addition to the
earnings growing tax-deferred.
Variable annuities are essentially mutual funds
with an insurance policy. Some give you the option, for a fee, to
limit potential losses by guaranteeing at least a portion of your
principal and interest. A drawback is the gains in an annuity are
taxed as ordinary income while mutual fund gains are taxed at the
usually much lower rate of capital gains. In addition, an annuity
leaves your heirs with the tax bill, while a mutual fund that's
inherited is granted a stepped-up cost basis so your heirs will
pay taxes only on gains that occur during their ownership.
then there's the expenses
Expenses are a fact of life when it comes to annuities -- contract
fees, administrative fees, mortality expenses and surrender charges.
Make sure your agent shows exactly what your policy will cost. Fees
for variable annuities are listed in the prospectus. The National
Association for Variable Annuities says management fees and other
expenses typically run from 1.5 percent to 2 percent. You also should
know what it would cost if you decide to cancel the contract.
"Annuities are meant to be long-term investments
for retirement," says Lewis. "If you withdraw the money
early you have to pay for the losses the company has suffered. The
company has paid commissions to administer it, underwriting -- they
put it out of their pocket and didn't get it back."
As was mentioned earlier, your annuity contract
is only as good as the insurance company that issues it. You can
check the financial stability of an insurance company through your
state's Insurance Division or through a number of companies such
Best and Standard
-- Posted: May 1, 2000