Annuities Good or Bad

An annuity as an investment isn't in and of itself good or bad. It can, however, be an appropriate or inappropriate investment for a particular individual. Like all investments, annuities come in many shapes and sizes. There are fixed annuities that pay a set amount of interest each year, variable annuities that pay a fluctuating rate and several variations on the two. Annuities are available for individuals and for married couples who can purchase them jointly. Annuities can be part of a qualified retirement savings plan or they can be purchased with after-tax dollars to shield assets. The first step to determining whether or not an annuity is good or bad is to determine the goals of the investment.

One of the most well-known reasons for purchasing an annuity is the risk an investor has of running out of savings during his or her lifetime. By signing a contract with the life insurance company that sells the annuity, an investor can feel relatively secure that if he or she has chosen a guaranteed lifetime income that payouts will be received each month, quarter or year for as long as he or she lives. For some people, especially those who weren't able to save an adequate amount of money for retirement, this can mean the difference between living comfortably in retirement and worrying about paying the bills. Most investors, however, are advised to have other accounts containing liquid assets.

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Reducing the Risk of Annuities

Over the past several years, competition among insurance companies has enabled consumers to choose from a number of new annuity products that are more investor-friendly. For example, most insurance companies now offer products that guarantee a payout to a beneficiary if the original contract owner dies either before the annuity is annuitized or if he or she dies early in the term.

An annuitant can usually choose between two options: A full return of premium to the beneficiary or payouts that will last for a set amount of time.  With the first option, an annuity owner chooses to have the entire premium amount paid to the beneficiary if he or she dies before payouts begin. He or she can further choose to have any interest that has accrued on the account paid to the beneficiary as well.

With the second option, the annuitant can choose to have the beneficiary receive the remaining premium either as a lump sum or as payouts over a certain number of years. In other words, if the annuity owner paid a total of $500,000 in premiums but dies after receiving only $100,000 in payouts, the beneficiary will receive $400,000. Or, if the annuity owner choses to receive payments for 20 years but dies in year 12, the beneficiary will receive the payouts for 8 years.

Are Annuities Good or Bad for Retirement Savings?

Some annuities are better than others for retirement savings. For example, a fixed annuity would not necessarily be a good retirement savings vehicle for a person under the age of 30. A person under the age of 30 should be focused on growth. While he or she doesn't have to take wild risks with his or her retirement savings, the investments do need to grow at a rate that will guarantee the amount needed at retirement will be there.

For older investors closer to retirement, annuities can be a good investment. Older investors need to focus on protecting their investments. They still need some investments that provide for growth, as they need to grow their money faster than inflation. But a fixed annuity is a relatively safe investment compared to equity and bond ownership.

Are Annuities a Good or Bad Hedge Against Inflation?

For investors who are concerned about inflation, a cost of living adjustment (COLA) rider can be purchased with most annuities. The adjustment increases the annuity payouts each year to counteract the effect that rising prices have on money. In other words, if an annuitant does not have a cost of living adjustment and receives $500 each month for 20 years, the value of that $500 will be less in 18 years than it is now. One of the most interesting ways to look at inflation is to see the increase in a gallon of milk and gas in the current year versus in the year the investor was born.

Are Annuities Good or Bad Tools for Estate Planning?

Annuities are typically not as good for estate planning as other types of investments. The cost basis that is used to determine the inherited value and taxes due on an annuity is calculated differently than on other types of investments. For example, the cost basis of equities is the difference between the value at the time the beneficiary inherited it compared to the time he or she sells it. Regardless of the price paid by the original owner of the equity, if the beneficiary inherits the equity at $15 per share and then sells it at $20, he or she pays gains on the $5 difference, even if the deceased paid $1 per share.  This is referred to as the "step up cost basis."

Variable annuities, however, do not allow for the step up. If an investor purchases a variable annuity for $200,000 and that annuity is worth $300,000 at the time of his or her death, the beneficiary will responsible for the entire gain of $100,000. Further, this distribution would be taxed at ordinary income rates, not the lower, more favorable capital gains rates.

This is often why some financial advisors will advise elderly clients to sell their annuities and place the proceeds in equity or bond mutual funds. These funds, once inherited by the beneficiary, would qualify for the more tax-friendly step up in cost basis, which would result in far less tax being paid. For those investors who are not necessarily comfortable purchasing equity or bond funds late in life, a single premium whole life policy would have the same effect.

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