Immediate annuities are designed to make payments to the annuity owner (the annuitant) that will continue as long as he (or she) lives. As its name indicates, an immediate annuity starts making regular annuity payments right away. In contrast, a deferred annuity enables a person to invest his money through an annuity contract that does not make any annuity payments to the annuitant until he (or she) decides to start receiving them. Deferred annuities may be worthwhile for even young adults. If you are considering purchasing a deferred annuity, there are some things that you should know about them, so you will be able to make an informed decision.
First, we will consider the major differences between the two basic investment types of deferred annuities – fixed and variable.
- Earnings potential: Fixed annuities are like certificates of deposit, except that the earnings are tax-deferred and, for some so-called fixed annuities, the interest rate that is paid may change from year-to-year. If the interest rate is actually variable, rather than fixed, the insurance company usually guarantees at least a certain minimum interest rate for each year and may offer a relatively high competitive initial rate for the first one to three years. Although fixed annuities provide a guaranteed minimum level of income for the life of the contract, this level of income may not keep up with the rates of inflation, especially after income taxes are taken into consideration.
Variable annuities are similar to mutual funds (i.e., they may have profits or losses each year), except that their earnings are tax-deferred. The annuity owner can periodically change how his (or her) investments are allocated among various types of securities funds offered by the insurance company. Usually, this can be done without needing to pay a fee. However, the owner of a variable annuity is limited to investing in only the securities funds being offered by the insurance company.
Typically, the stock funds that are offered under variable annuity contracts have substantially higher long-term returns than fixed annuities and, therefore, variable annuities provide the potential for annuity owners to keep pace with, if not exceed, the rate of inflation. However, because they are a lot like mutual funds, variable annuities may sometimes provide lower cumulative returns than fixed annuities for periods as long as 10 years or more.
- Return of principal: Fixed annuities guarantee to pay back the original investment, plus the interest that has been earned. Conversely, most variable annuities do not guarantee that the original investment will be repaid. However, some variable annuities guarantee to pay a total amount equal to the greater of either (a) the annuity owner’s total payments plus a minimum return, or (b) the value of the account. However, there is an extra fee for this guarantee.
Next, be aware of the tax considerations regarding deferred annuities.
- Amount that a person can invest each year: There is no statutory limit as to how much a person can invest each year in a non-qualified annuity, but for a tax-qualified annuity there are statutory limits, except for rollovers. [Note: A tax-qualified annuity is funded with money applicable to a retirement plan such as a pension, a 401k, or an IRA, whereas a non-qualified annuity is funded with money from some other source.]
- Tax deductibility of amounts that are invested: The amounts that are invested in a non-qualified annuity are not deductible for income tax purposes, whereas the amounts that are invested in a tax-qualified annuity are deductible, if they are not from a rollover.
- Tax deferral of income: As previously indicated, all earnings (interest, dividends, capital gains, etc.) by a deferred annuity are tax deferred (i.e., earnings are not taxed until they are withdrawn). This is true regardless of whether the annuity is tax-qualified or not.
- Tax consequences of switching funds: For a variable annuity, the owner can switch among the various funds offered by the insurance company, without tax consequences. In contrast, switches among mutual funds that are not associated with a variable annuity result in taxable gains and/or losses, if the accounts are not tax-deferred or tax-exempt.
- Funds withdrawn before age 59 ½: Generally, if funds are withdrawn from a deferred annuity before the owner reaches age 59 ½, a 10% tax penalty on the accumulated earnings that are withdrawn is imposed by the federal government. This penalty is in addition to the ordinary income tax that is due on the accumulated earnings when they are withdrawn. With a tax-qualified deferred annuity, the taxes and penalty apply to withdrawals of principal, as well as to withdrawals of accumulated earnings.
- Funds withdrawn after age 59 ½: All accumulated earnings withdrawn by the annuity owner after the age of 59 ½ are subject only to ordinary income tax (i.e., there is no tax penalty). For variable annuities, the fact that all earnings that are paid out are taxed at ordinary income tax rates can be a significant negative, because the long-term gains are not taxed at the usually much lower capital gains tax rate. The greater the difference between the tax rate on ordinary income and the tax rate on capital gains at the time money is withdrawn by the annuitant, the less attractive a variable annuity is when compared to common stock investments made separately (i.e., not through a deferred annuity).
- Step-up in cost basis at death: Annuities have no step-up (i.e., increase) in cost basis when the annuity owner dies. Therefore, if annuity benefits are inherited, the heir(s) will owe income taxes on the amounts received in excess of the amount invested by the annuitant, minus any withdrawals by the annuitant. In contrast, mutual funds and most other types of investments have a step-up in cost basis that enables them to pass income-tax free to the heir(s).
It is also important to give adequate consideration to fees and expenses.
- Many variable annuities charge a relatively high annual fee for expenses – up to 2% of assets, which is almost twice that of the average mutual fund. These fees lower the potential return that the owner of a variable annuity can earn.
According to an article in Forbes magazine (1-7-91),
There’s no use saving money on taxes only to waste it on fees. The reality is that, unless you hold on to [an] annuity for a long time, tax-deferred annuities offer only a small tax advantage yet cost a lot more in overhead than ordinary funds. In short, most of the benefit from the tax savings goes to the middlemen, not to the investor.
The article goes on to state that the variable annuity owner’s tax savings for the first 20 years are consumed by fees for death benefits and expenses other than those incurred in managing the money.
Similarly, a Wall Street Journal article (6-30-97) states,
Because you are paying an extra layer of fees. . . it can take 10 to 20 years before you actually enjoy the benefits of the tax deferral, compared with an equivalent return on a mutual fund.
Likewise, an article in Money magazine (Sept. 1997) says,
Financial planners estimate that to overcome the unfavorable tax-rate spread and an annuity’s sky-high insurance and investment fees, an investor facing a 28%-or-higher tax on withdrawals would have to rack up tax-deferred gains for 15 to 25 years to come out ahead. [Note: For people in a lower income tax bracket, the period necessary to come out ahead would be even longer.]
- With the exception of relatively small (10%-15%) withdrawals, most deferred annuities charge a surrender fee on amounts that are withdrawn before the annuity matures. The surrender fee may be 10% or more during the first year and then gradually phase out over subsequent years.
You may also want to consider comments about variable annuities made in a Forbes magazine article (2-9-98). [No comments were made in the article with regard to fixed annuities, which apparently are regarded as less controversial.] The article makes the following rather harsh statements:
A variable annuity is a mutual fund-type account wrapped in a thin veneer of insurance that renders the investment earnings tax-deferred. The tax deferral is just about the only good thing you can say about these investment products. Almost everything else about them is bad: the high – sometimes outlandishly high – costs, the lack of liquidity, the fact that the annuity converts low-taxed capital gains into high-taxed ordinary income. That tax deferral comes at a very high price.
In light of the information that we have presented, anyone who is considering purchasing a variable annuity certainly should not rush into making such a commitment and should give ample consideration to other investment alternatives.
Fixed indexed annuities (also known as equity-indexed annuities or FIAs) have characteristics of both fixed annuities and variable annuities. They provide greater potential for gains than do fixed annuities, but they also have greater risk. Conversely, they offer less potential for gains than variable annuities, but they have less risk.
- FIAs should be regarded as alternatives to other interest income types of investments, including fixed annuities. However, FIAs are designed for accumulation, not for regular income. Even if there is no stipulated penalty for withdrawing a certain percentage of the balance each year, funds that are withdrawn may not be credited with earnings for the year-to-date period before their withdrawal.
- FIAs are for investors willing to give up considerable potential for gains in exchange for assurance that there will be little, if any, loss of principal. Even for money that is not subject to a penalty if it is withdrawn before the annuity matures, loss of principal is possible if the FIA guarantees only that the investor will receive 90% of the premiums paid, plus a low minimum rate of return that is applied to 90%, not to 100%, of the premiums paid.
- Changes in the value of an FIA usually are based on a stock index such as the S&P 500, the Dow Jones Industrial Average, or the NASDAQ 100. Generally, only changes in the prices of the stocks in the index are reflected (i.e., dividends usually are not reflected, so a very significant part of the total returns achieved by stocks is not taken into consideration).
- A so-called “participation rate” determines how much of the gain in the applicable index will be credited to the annuity, but this percentage can be misleading. Depending on the base to which the participation rate is applied, a 60% participation rate may actually be better than a 100% participation rate. Therefore, investors need to know the exact definition of the base to which the participation rate is applied.
- Many FIAs put an upper limit on the percentage return that may be earned in any year, or they subtract a spread, margin, or asset fee from any gain in the index linked to the annuity. And, some FIAs permit the insurance company to change these factors either annually or at the beginning of the next term of the contract.
- If an FIA offers a so-called “bonus,” it probably will be at the expense of a lower participation rate or a longer surrender period and higher surrender charges.