Fixed Annuity Disadvantages
Fixed annuities are designed for long-term investment. Their main disadvantages — IRS and insurance company penalty fees — are significant factors only with premature withdraw. Beware of these disadvantages:
- 10% IRS Penalty: Income withdrawals before the age of 59.5 are charged a 10% tax penalty by the IRS.
- Not Considered a Capital Gain: Growth is tax-deferred, but eventually income is taxed an ordinary income tax rates, not capital gains.
- Withdrawal Charges: The insurance company usually imposes a penalty if withdrawing over the yearly allotment.
- Single Premium: Further monies cannot be added to the same annuity contract (although additional contracts can be purchased).
Understanding the IRS Penalty
Pulling out money from any annuity prior to the age of 59.5 will result in a 10% tax penalty on top of the ordinary tax rate. This means a potential tax rate of 45%. Needless to say, the IRS penalty can eat into your growth substantially. This is why annuities are considered a retirement investment vehicle and aren't well suited for younger investors. There are however two streaks of silver lining:
Firstly, the IRS will never assess taxes on your principle. In annuity investment, income is all that's ever taxed, and in this case, only that which you earn beyond your initial investment would be subject to the 10% IRS fee. At worst you make less money; you never lose money.
Secondly, this penalty can be completely avoided. For an immediate fixed annuity, don't invest unless you're over 59.5 years of age. For a deferred fixed annuity, make sure you'll be over 59.5 when it comes time to withdraw income. You always have the option to rollover one annuity into another indefinitely, so you needn't worry about timing the contract's maturity date to your 60th's birthday. Other ways the IRS penalty can be avoided:
- Death of the annuitant
- Disability of annuitant
Death or Disability of the Annuitant: The IRS waives the 10% penalty if the annuitant dies or becomes disabled.
Annuitization: If you choose to disburse the annuity within one year of signing the contract (otherwise called Annuitization), the IRS tax penalty is waived.
How Fixed Annuities are Taxed
Don't mistake tax-deferred growth with tax-free growth. While the annuity is active your money will grow tax-free, but eventually, when you or a beneficiary starts to withdraw income, it will be subject to the ordinary tax rate of the individual making the withdrawal.
Why is this a negative? Because, in relation to other investment options like CDs or mutual funds, you could have been charged the more favourable capital gains rate. In a worst case scenario your tax bracket could be as high as 33%, State + Federal. That's more than double the 15% capital gains rate. There are however two mitigating factors:
Further Deferral: Taxes can be postponed from spouse to spouse. If one spouse dies and names the other as beneficiary, the annuity transfers over to the surviving spouse without taxation. Furthermore, the last remaining spouse can transfer the annuity to an heir who will have up to 5 years of additional tax deferral.
You Decide When to Withdraw: Because you can choose to withdrawal income some years, while not others, the savvy investor will take advantage of times when he or she is in a lower tax bracket to make larger withdraws. Most pre-retirees drop in tax bracket upon retirement, allowing them to save up to 15%.
Tax-Deferred Growth Still Better: All things being equal, the advantages of investing in a fixed annuity tend to outweigh those of investing in a CD or mutual fund. Over a long timeframe, tax-deferral + standard income tax beats out annual tax + capital gains tax. Consider the savings in the following example:
Tax-Deferred Growth Example
John and Joe both invest $500,000 for retirement. John invests in a fixed annuity for 20 years, Joe invests in CDs or a taxable money market for the same timeframe. Let's assume both earn an annual return of 9% and fall into the same 33% tax bracket.
After 20 years, John has accrued $2,802,205 while Joe only $1,612,669. But Joe's already paid his taxes. John has yet to pay his share. 30% of $2.8M minus the $500k premium (which isn't taxed) yields John $2,041,478. Not bad, John's fixed annuity beat Joe's CD by over $400,000!
Even if Joe invested in a completely tax-free money market at 5% (a typical rate), he still wouldn't beat the fixed annuity. In fact, he'd make out worst of all.
Don't Just Shop, Implement a Solid Retirement Strategy
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Withdrawal Charges Explained
A withdrawal charge is imposed by the insurance company whenever you try to take out cash from an annuity before it's maturity date. Some annuity contracts don't have withdrawal charges at all, but most feature a penalty that phases out over time.
For example, a typically fixed annuity might stipulate a 4% withdrawal penalty with a 5 year phase-out schedule. For this annuity, a withdrawal in the first year results in an 5% penalty. In the second year it drops to 4%, then 3%, then 2%, then 1%, and finally, after 5 years, you can withdrawal as much as you like penalty-free.
Withdrawal fees are a downside of virtually all annuity contracts, but they far from render these products useless.
Firstly, nearly every annuity has an annual minimum that can be withdrawn penalty-free. This is commonly 10% after the first year. That's typically sufficient to cover most rainy-day scenarios.
Secondly, 75% of annuity investors never withdrawal their money prematurely. Remember, an annuity is a long-term investment that should be made with excess funds. As long as you hold a mixed portfolio of savings, with other, more liquid assets, you should be fine. And the disincentive to withdrawal in excess of emergency needs will help you keep discipline with your retirement savings, which is not meant to be spent prematurely.
The final three ways to avoid withdrawal charges are:
The Single Premium Nature of Fixed Annuities
A minor disadvantage, immediate fixed annuities prohibit re-investments in the same contract. This makes sense really, because the fixed annuity works off the fact that an investor locks in a set interest rate for x number of years based on today's projected interest rates. The insurance company would not be able to fulfil its obligations if contract owners could double-down when interest rates rose.
This disadvantage is more a logistical annoyance. You're never limited in the amount of annuity contracts you can open. If you want to invest more monies in the future, simply purchase a second contract with an up-to-date rate.
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