5 pros and cons of investing in annuities

Make money last: How to buy a pension
By Jean Chatzky

At face value, annuities offer a solid deal: guaranteed income for life. But they are not the most straightforward of products.

Annuities can be a cash cow for insurance companies and the people who sell them -- making it important for you to understand them and trust your source of information.

There may be less costly ways to reach the same outcome with another investing tool. As with any big investment, discuss what is right for you with a trusted adviser who knows your complete financial picture.

Beyond sheer complexity, annuities have certain characteristics.

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Mortality credits

Annuities are insurance against outliving your money, and the reason they make sense for some people is the mortality credits.

Mortality credits should be regarded as a threshold investment return that is required to beat the income from the annuity, wrote Moshe Milevsky, associate professor of finance at York University in Toronto.

It's complex stuff, but here's a simple explanation: Imagine that 10 people at age 75 all invest $1,000 at 5 percent interest.

Collectively they put in $10,000 and receive $500 interest. Everyone gets back their $1,000 plus $50.

"Now say only the people at the end of the period who are alive will share in the proceeds. At the end we know there will be $10,500 but we assume only nine people will be alive," says Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis.

"If there were nine people left and no insurance company involved, each person will collect $1,167 so the return jumps to almost 17 percent," he says.

The difference between 5 percent and 17 percent -- 12 percent -- is the mortality credit.

The older you get, the larger the mortality credits get. By buying an annuity that pays income for life, you're betting that you will live longer than the average person who buys an annuity.

Bottom line: For many people, it won't really pay to buy an annuity until their mid-70s.


Though deferred annuities allow you to put off paying taxes, they don't eliminate taxes altogether.

The capital gains tax rate is zero percent for the two lowest tax brackets and 15 percent for almost everyone else. A 20 percent tax rate on net capital gain applies to the extent that a taxpayer’s taxable income exceeds the thresholds set for the 39.6 percent ordinary tax rate. There are a few exceptions, including net capital gains from selling collectibles, which are taxed at 28 percent. That's still lower than some ordinary income tax rates, which go as high as 39.6 percent.

That means long-term gains on most investments that you sell in a taxable account are taxed at lower rates.

But withdrawals from annuities get a different tax treatment than regular investments.

In a deferred annuity, "If I'm in the first period, the accumulation period, and I pull money out, it's LIFO -- last in, first out. So what I'm withdrawing first is interest. So it's 100 percent taxable income: no capital gains rate, no preferred dividend rate," says Mark LaSpisa, a certified financial planner with Vermillion Financial Advisors in South Barrington, Illinois.

After annuitization, the income investors receive is taxed slightly differently. Part of the payment is considered return of principal, so it is untaxed.

As for the earnings: "Part will be considered income and part will be considered capital gains," says LaSpisa.


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