Index Annuity Disadvantages

Overview

Like all investments, index annuities have their disadvantages. Most of these are common to all retirement savings instruments, including 401(k)s and IRAs, but some are exclusive to annuities. When an index annuity is part of a retirement plan, its cons are outweighed by its minimum guaranteed rate and growth potential. Even so, take notice of the following disadvantages:

  • 10% IRS Penalty — Withdrawing income before the age of 59.5 results in a 10% IRS tax penalty.
  • Not Considered a Capital Gain — Although tax-deferred at first, income is eventually taxed at ordinary rates, unlike stocks.
  • Administration Fees — Like mutual funds, some index annuities charge a 1-3% annual management fee.
  • Withdrawal Fees — Withdrawals exceeding the annual allowance incur an insurance company penalty.
  • Vesting Schedule — Earnings diminish when withdrawn early. A vesting schedule determines by exactly how much.
  • Single Premium Contracts — Most contracts allow a single lump-sum investment. Further deposits require opening another contract.

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The 10% IRS Penalty

Young investors beware. Like all annuities, the indexed variety incurs a 10% IRS tax penalty for premature withdrawals. All income withdrawals prior to the age of 59.5 are considered premature. Obviously a 10% penalty eats into earning substantially and should be avoided at all costs. Consequently, index annuities are not suitable substitutes for CDs or mutual funds outside a retirement plan. If you’re seeking pre-retirement wealth, look elsewhere. If you’re committed to save for retirement, the 10% tax penalty is irrelevant.

It might seem reasonable to avoid the 10% penalty by withdrawing principle rather than income, but the fact that most annuities force income withdrawals before principle withdrawals undermines this strategy.

Index Annuity Taxation

One of the downsides of annuity income is that it's not considered a capital gain. When the capital gains rate is substantially lower than ordinary income taxes, annuity investors miss out. That said, the two closest counterparts of index annuities, mutual funds and CDs, are taxed as ordinary income too. Stocks are one of the few financial instruments that quality for capital gains, but their excessive exposure make them unsuitable for retirement savings.

Unlike mutual funds, CDs, or even stocks, index annuities offer the unique benefit of tax-deferral. With annuities, income is taxed only after withdrawal, allowing you to earn compound interest on money that you would have gone to the IRS had you invested in a mutual fund, CD, or stock. Because index annuities are typically held for 5, 10, or even 20 years, compound interest on deferred tax payments will add up substantially.

Administration Fees

Index annuities present a tantalizing promise: stock market-style growth with none of the risk. Obviously insurance companies can't assume all the risk themselves. Most insurers compensate by giving you a portion of the index’s raw growth, as opposed to the whole thing. Some insurers charge a mutual fund-style administrative fee. And some do both.

Of those that charge charge fees, 1-3% is typical. This percentage is deducted from your account every year. Fees are deducted prior to crediting and regardless of market performance. Administrative fees may be fixed or variable.

While it is possible to find index annuities without administrative fees, counter-intuitively, they may be welcome. The insurance company always charges a premium for covering losses during negative years. This cost can be paid via a higher participation rate, a lower minimum guarantee, a less flexible vesting schedule, or an administration fee. Depending on market conditions, it might be preferable to pay a fixed annual fee in return for a higher participation rate.

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Withdrawal Fees

Withdraw fees of 5-10% are common for any type of annuity. The important note is that these fees aren't assessed for every withdraw. Your index annuity contract will spell out a maximum penalty-free amount that can be withdrawn on a yearly basis. Withdrawals over this allowance are then subject to fees.

Withdrawal fees phase out over time. Each year the fee becomes smaller and smaller as your annuity approaches the end of its term. Although a serious disadvantage for some, a majority of investors don't make early withdrawals. Of those that do, most stay within their annual, penalty-free allowance.

Vesting Schedule

Unlike other annuities, index annuities tend to shave off a portion of your earnings if you decide withdrawal early. The vesting schedule outlined in your index annuity contract determines how much of the earnings you retain when withdrawing on the 1st, 2nd, or 3rd year of your term. A sample vesting schedule might look like this:

  • 1st year: 0%
  • 2nd year: 30%
  • 3rd year: 60%
  • 4th year: 90%
  • 5th year onward: 100%

The schedule above shows the percentage of earnings retained when withdrawing at a given period in the contract. The insurance company designs the schedule to disincentive investors from pulling out money early into the term.

Those intending to invest in index annuities as part of a retirement savings plan should not be put off by vesting schedules. Statistics show that over 75% of investors don't withdrawal from their annuities before the maturity date.

Single-Premium Contracts

A minor disadvantage of most index annuities is the single-premium nature of their contracts. Meaning, you only get one chance to invest in the same annuity contract. "single-premium" simply means, one large up front deposit. Later, if you decide to invest more funds, a second contract would be required. And while the insurance company will gladly issue multiple contracts, there's no guarantee you'll get the same favourable terms, as market conditions were likely to change.

Index annuities resemble fixed annuities more than their variable counterparts. This makes sense because both fixed and index annuities guarantee principle and lock in a some form of minimum rate. Variable annuities, on the other hand, make no promises or lock-ins, allowing the convenience of monthly re-investment.

For help finding the best index annuity products, and for an objective consulation of their pros and cons, contact a licensed annuity specialist. Start Now.

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