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Are Annuities Appropriate for Your Retirement Nest Egg?

They may be, but beware of high fees, generous commissions and strict rules that can lock up your investment longer than you wish

By C.D. Moriarty

Higher interest rates and anxiety over the stock market and economy have pushed more consumers to buy annuities, which is neither a good nor bad investment decision. Understanding annuities before you buy is something that most people fail to take the time to do. Instead, they are swayed by the promise of "lifetime income" or are sold on great features touted by the salesperson.

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Before you sign any contract, ask for a copy to review at home. Then consult with an objective party like a Certified Financial Planner, Certified Public Accountant or other investment advisor.  |  Credit: James Kern

In simplest terms, annuities are complex contracts that investors buy from insurance companies with a lump sum or flexible payments over time. In return, the insurance company invests the payments to generate a certain income for the buyer that is paid monthly, quarterly, semiannually or annually, typically for life.

Annuity Facts

Four basic facts to know about annuities:

  • They are insurance contracts.
  • They provide regular income, immediately or in the future.
  • There are three main varieties — fixed, variable and indexed — each with its own level of risk and payout potential.
  • The income from an annuity is typically taxed at regular income tax rates, not long-term capital gains rates, which are often lower.

Some 401k plans offer an annuity as one investment option within the plan. They also can be purchased from independent insurance sales representatives.

Annuity Questions

Some insurance representatives take advantage of clients' fear of outliving their savings to sell annuities that are inappropriate for clients but earn the salesperson a great commission.

Before buying any annuity, be sure you understand your retirement needs and the following details of the product being sold to you:

  • The cost to you.
  • The commission to the sales representative.
  • The "surrender charge," or penalty you must pay if you withdraw money from an annuity during its "surrender period," which may last six to eight years after you buy it.
  • The "underlying investments" in which the insurance company will invest to make the money they pledge to pay to you.
  • How you will be taxed when you withdraw money from the annuity.
  • Beneficiary benefits, or the amount your beneficiary would receive if you died. This could be the current market value of the underlying investments; their peak value since you bought the annuity, even if the current value is lower than that; or some other option.

Beware of Industry Jargon

Knowing the details makes sure the product is right for you. Annuity contracts are written by insurance company lawyers using legal jargon that people who are not lawyers may find difficult to understand. Review what it says before you sign. And keep a copy of your contract.

Participants in defined-contribution plans can choose specific investments and now one of those options may be an annuity.

Most companies have stopped offering defined-benefit pension plans, which promise a certain payout for as long as the former employee is alive, in favor of 401(k) plans, which promise only to contribute to retirement savings accounts and make no promise about how much, if anything, former workers will receive.

Companies have embraced 401(k) plans over the last four decades because they are less expensive to maintain than defined benefit plans, especially as people live much longer than they did half a century ago. People with 401(k)s or other "defined contribution plans" — such as 403(b)s for non-profit groups and IRAs for independent workers — miss the security of monthly pension checks; many have chosen annuities to fill this void.

Participants in defined-contribution plans can choose specific investments and now one of those options may be an annuity. The government now allows them as a choice in their retirement plans — because the insurance companies have a big lobby. They fill a gap but are not a one size fits all.

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Annuity Specifics

An annuity is a guarantee to pay a fixed sum of money. There are diverse ways to invest within annuities, or you can let the insurance company decide.

An important feature to consider with any annuity is its tax treatment.

Also, you need to know when you want to start collecting your annuity. As its name suggests, an immediate annuity is a contract that converts a lump sum to cash flows as soon as you sign the contract. A deferred annuity is set aside for a certain term before you begin to receive cash flows. In both options, the funds are invested, and the proceeds accumulate tax-free until you begin receiving payments. Most deferred annuities start their payouts after age 59½.

Annuity sales representatives must be licensed to sell this insurance product but may not be licensed to sell other investment products. If a sales rep does not offer you investment options beyond annuities, they may be licensed to sell only annuities. You may not learn about other investment options that could be more appropriate for your circumstances and risk tolerance.

No Tax Break at Either End

An annuity insures the life of the annuitant, the person who buys the policy. Children, spouses and next of kin do not receive the same amount that the annuitant would if they lived in most cases. Be sure you know what you are leaving your children or if the annuity has a guaranteed payout amount.

An important feature to consider with any annuity is its tax treatment. While the balance grows on a tax-deferred basis, the disbursements you receive are subject to federal income tax. The funds you receive are taxed at your regular income-tax rates. By contrast, other retirement investments are taxed at the long-term capital gains rate, which is generally lower.

Additionally, unlike a traditional 401(k), your contribution to a standalone annuity does not reduce your taxable income in the year you make the contribution. For this reason, financial planning experts often recommend that you consider buying an annuity only after you have contributed the maximum to your pre-tax retirement accounts for the year.

Before You Buy, Read Carefully

Remember you are signing a contract with a large insurance company whose business aim is to make money. Before you sign, ask for a copy of the contract to review at home. Then consult with an objective party like a Certified Financial Planner, Certified Public Accountant or other investment advisor.

If you have to pay someone to review the policy before you purchase, remember that you may be saving money in the long run by asking the right questions and getting a disinterested third party to weigh in. Consider your full retirement planning timeline before purchasing.

There are times when it may be appropriate to make a purchase to cover your needs. Sometimes an annuity makes sense to cover long-term care or as a vehicle for charitable giving.

If you want a steady stream of income in retirement, you may already have one: Social Security. You earned it, it grows over time and it is adjusted for inflation. Social Security is an annuity of sorts, with no sales commission.

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C.D. Moriarty C.D. Moriarty, CFP, is a Vermont-based financial speaker, writer and coach. She can be found at MoneyPeace.com. Read More
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