The world of insurance and financial product sales is a large confusing one. First, you have the myriad of different products that already exist. Annuities, Whole Life Insurance, Indexed Annuities, Long-Term Care, Variable Life Insurance, Individual Health Insurance, Accidental Death & Dismemberment, etcetera, etcetera. Each comes with their own text book of explanations, definitions and specific rules. Then you have the tax implications of buying and using these products for yourself. Finally, you know you pay something to the broker that sold them to you, but you’re not entirely sure how much that “something” is.
There are a lot of financial products to be discussed, but since the baby boomers are the largest generation and are nearing retirement, and fixed annuities are often products aimed at retirees, I thought I’d give a quick overview of what they are and how they work. This is not comprehensive; but if you’ve been approached about buying a fixed annuity, or if you’re considering it, please take a minute to read the following. It might just save you a big realization of regret later on.
Fixed Annuities come in a number of different shapes and sizes. There are single premium, installment, joint life, period certain, and a whole host of other types. There are also a bunch of riders and add-ons that you can get too. Just about every major financial or insurance company in the country has its own suite of fixed annuities.
Despite these details, all fixed annuities essentially work the same way. There are four basic components to think of in a fixed annuity: how they are funded, how they work, how they are taxed and how they are cancelled.
How They are Funded
Fixed annuities are normally funded in one large lump-sum payment, but can also be funded in installments over a relatively short period of time. This payment could be old 401k money, a large chunk from your savings account, the balance in your Roth IRA or even the cash value from an old whole life insurance policy via a Section 1035 exchange. There are really no limits on the type or kind of assets that can be used to purchase an annuity, and the broker usually doesn’t care what those assets were previously used for or how they are taxed. They are paid a commission on the sale of the product.
How They Function
The term “annuity” is derived from the idea of annuitization, which is receiving a stream of payments for a defined period of time. They work in the following way. You purchase a fixed annuity with a large lump-sum payment. That money is given directly to an insurance or financial company and you will never have access to that same lump-sum amount of money again. Per a contract with the company, they make small monthly or annual payments back to you for a specified period of time (period certain) or the duration of your life (life only). These payment amounts are usually a specified percentage rate, determined by the company. They may be quoted as a “7% return annuity” but remember this is money that you’ve provided to the company. You pay them 100% of the total of the premium (for example $500,000) and they give you 7% a year ($35,000) for life or the period certain. That means it will take you over 14 years just to get your initial investment back. This doesn’t include the tax consequences which reduces the payout (we will explain this later). You have now gone 14+ years with a maximum return of 0%. Therefore every subsequent payment will have to be taken into consideration relative to the total time passed.
For example, if you buy a single life only immediate annuity with 7% payout for $500,000, and you live for 30 years, during that time you will have received a total of $1,050,000. Half of that was already your money (principal) so you gained an extra $550,000 or 110% return. That sounds great, until you realize it was over the course of 30 years. So your average compound annual return was 2.5%, which is less than the historical rate of inflation. And that’s if you live that long. If you die at any point of the “life only” annuity, the company keeps the money and doesn’t make any additional payments to your heirs. Compare that 2.5% annuity return to the S&P 500 over the last 30 years which yielded 8.56% plus dividends. The same $500,000 investment would have been worth $5,875,773 not including dividends.
How They are Taxed
Most advisors and the vast majority of clients don’t understand that an annuity has its own unique set of rules with regard to the tax treatment of the original premium and the subsequent payments. There are essentially two tax classes for annuities. Non-Qualified and Qualified.
A non-qualified annuity would be purchased using cash derived from the sale of securities in a regular brokerage account, dividend income, interest income or cash in a savings account. Many advisors tout the “tax deferred” nature of annuities but they fail to recognize that the income derived from them is taxed at ordinary income rates, instead of the much more favorable capital gains and qualified dividends rates you could get using an individual brokerage account. Also, annuities receive LIFO (last in first out) tax treatment. This means that your monthly payments will have a portion of them included in your taxable income. Alternatively, you could invest the same amount of money in a brokerage account of high qualified divided paying stocks and pay the qualified dividends tax rate on the income received, all of which would be a return above the initial capital you invested, not just a return of your investment principal like an annuity. On top of all of this, you also subject your assets to the 59½ rule (same as IRA’s) so you receive a 10% tax penalty on any distributions before that age.
A qualified annuity on the other hand is funded with cash from either an IRA, Roth IRA or a rollover of a qualified employer retirement account. Unfortunately, since annuities have their own rules, they don’t take into consideration two very important features of these retirement accounts: Required Minimum Distributions (RMD) for IRA’s or the Five Year Costs Basis Access rule for Roth’s. When you fund a qualified annuity with an IRA, you are still responsible for RMD’s starting after age 70½. This starts as a small percentage the IRS requires you to distribute so you have to pay taxes, but it grows over time. Since your annuity payments are fixed, you might be forced to pay a penalty or make changes to the annuity contract so you can meet your RMD. This will be an expensive issue to overcome. With regard to a Roth IRA, many advisors and clients don’t realize you have complete tax and penalty free access to your cost basis as long as your first Roth IRA was started at least 5 years prior. Normally, if an expense came up, you could pull out all of the money you’ve contributed to your Roth IRA to meet that need. Unfortunately with an annuity, your liquidity and cost basis are locked up and you have no access to them. There are more tax details, but these two are the main issues people run into.
How They are Cancelled
Finally, if you discover you’ve made a mistake in purchasing an annuity… you might be looking at a hefty surrender charge or cancellation fee. These can be anywhere from 8% of the original premium, all the way up to 40% for cancelling a contract. That is a serious price to pay for a fancy financial product.
Ultimately, the allure of annuities is the pipe dream of exchanging stock market risk for guaranteed income payments. In reality though, you’re only exchanging investment risk for inflation risk, and losing tax and liquidity benefits along the way. The next time you hear about the next best annuity, think long and hard before you write a check. You might just be locking up your money and throwing away the key.
