Investors looking for a safe haven for their fixed-income dollars or retirement savings often buy annuities. Annuities are sold only through insurance companies. They are a contract between you and the insurance company and typically provide for tax-deferred earnings.
Annuities contain a number of insurance guarantees, including the option to "annuitize," or turn the principal into a lifetime stream of income. But investors may find that fees can be steep and earnings are taxed as ordinary income even if it's a long-term capital gain.
Annuities, even when sold though a bank, are not insured by the Federal Deposit Insurance Corp. The safety of your principal rests on the financial strength of the annuity provider. If the insurance company fails, your annuity might be covered up to $100,000 by your state's guaranty association. The associations operate under their state laws. What they cover and how much they pay varies from state to state.
Pros and cons of annuities
|What's good about 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?|
- Fees and commissions can be high and can 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 35 percent income-tax bracket and your capital gains tax rate is 15 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.
You pay the insurance company a certain amount of money and the insurance company guarantees you certain periodic payments for the life of the annuity. This can amount to a lifetime stream of income. The insurance company is betting it can invest your deposit and make more money off it than it will have to pay you.
Annuities often offer higher interest rates than certificates of deposit, but the term "fixed-rate" is a misnomer when it comes to annuities. Unlike a CD, where the rate is fixed for the full term of the CD, fixed-rate annuities have no maturity date and often guarantee a rate only for the first year. The interest rate usually drops after the guaranteed period and is adjusted annually.
The insurance company may impose a penalty period for several years where you'll pay steep surrender charges if you withdraw money during that period. Withdraw money in the first year and you may pay an 8-percent penalty. The penalty typically decreases by 1 percent a year after that.
Since there's a tax-deferral feature to annuities, you may have to pay a hefty 10-percent penalty to the IRS if you withdraw money before age 59½. Another consideration is that earnings on annuities are taxed as ordinary income by the IRS regardless of how long you've held the investment.
Variable annuities combine elements of life insurance, mutual funds and tax-deferred retirement savings plans. While their hybrid nature offers investors some features they can't get elsewhere, it also makes them complicated products.
When you invest in one of these, you select from an array of mutual funds in which to allocate your investment dollars. Typical offerings might include balanced mutual funds, money market funds and several international funds, among others. Along with the tax-deferral benefit, you also get income guarantees you can't get with other investments. For instance, variable annuities, for a fee, offer a death benefit feature.