You pay $1 million upfront and receive $5,000 a month after retiring. Simple, right? Unfortunately, annuities are rife with complexities that can prevent a clear understanding of their benefits and potential pitfalls. This insurance product is often considered a safe investment, but annuities have their own risks. Here’s why they might be a bad investment for you and what you should factor into your decision-making process.
If you’re on the fence about adding an annuity to your retirement plan, a financial advisor can walk you through the specific benefits and drawbacks for your situation.
What Is An Annuity?
An annuity is a contract you can purchase from an insurance company guaranteeing income for a specified length of time. You’ll receive income in monthly installments in an amount the company sets when you first fund the policy.
There are several types of annuities, but they all work on a similar principle: You make a lump-sum payment or a series of payments to the annuity issuer. The money in your annuity grows tax-deferred through interest payments or investments in a market index or stock portfolio.
In return, you receive regular disbursements, which can be immediate or begin at a later date. Additionally, these payments can last for the rest of your life or a preset period, such as a decade.
Reasons to Purchase an Annuity
Annuities play a pivotal role in financial planning with their unique set of advantages. Here are four common reasons why you may want to purchase one:
Reliable, Long-Lasting Income
Annuities provide a steady stream of income for a period between five years and the rest of your life. This feature offsets longevity risk (the chance of outliving your savings during retirement). In addition, annuities protect against loss by guaranteeing your principal amount. This way, even if the investments you choose for your annuity underperform, you’ll preserve your initial investment. As a result, annuities ensure a regular income stream whether the stock market soars or nosedives.
Annuities come in various types, each tailored to different financial needs and risk profiles. You can choose between fixed, variable, indexed, or a combination of these options. Additionally, you can often customize features like death benefits, withdrawal options and riders, allowing you to create an annuity that aligns with your specific financial goals.
Plus, you can create an annuity at any age. This feature allows you to open one shortly before you retire or implement it as part of your retirement savings strategy early in your career.
Lastly, you can transfer cash between annuity types tax-free. Doing so lets you change your income type and match your risk tolerance. You can also place an annuity in a 401(k) or IRA to consolidate your investments.
Annuities offer tax-deferred growth for retirees. This advantage means your annuity’s earnings aren’t taxed until you start receiving payments. This way, investments grow faster than a brokerage account, which is subject to capital gains taxes whenever you trade an asset. Additionally, when you start receiving annuity payments, only the portion representing earnings (not your original principal) is subject to income tax.
Inflation erodes the purchasing power of money over time. Some types of annuities, like indexed annuities, have features that tie returns to an index, such as the S&P 500. This aspect helps your annuity payments keep pace with inflation, providing a potential hedge against rising living costs.
Additionally, certain annuities offer a rider that accounts for cost-of-living adjustments (COLAs), which can increase your payments periodically to keep up with inflation.
Reasons Annuities Might Be a Bad Investment for You
Unfortunately, annuities are not free from pitfalls. Here are eight ways this investment can ruin your nest egg:
Annuities Can Be Incomprehensible
Annuity contracts often contain complex jargon, various payment options and intricate investment structures. This tangled web of terminology and numbers can make it challenging for individuals to fully understand the annuity’s terms, risks and benefits.
Some annuities can come with exponentially higher fees than other investment vehicles. Annuities can have sales commissions, administrative charges and investment expenses. In addition, sales agents might not discuss an itemized list of fees upfront, obfuscating how much the contract will cost. These fees can erode a significant portion of your potential returns, making other investment options more cost-effective.
Annuities produce long-term income and many have restrictions on withdrawals. Specifically, annuities typically surrender charges if you take a distribution or cash out the annuity before the agreed-upon age in the contract. Therefore, you lock away your cash by funding an annuity, preventing yourself from investing in other assets or using your lump sum as an emergency fund.
Withdrawing funds from an annuity before a certain age (usually younger than 59½) results in a 10% penalty tax on the withdrawal. Annuities share this characteristic with IRAs and 401(k)s, so the lesson here is that an annuity is a retirement savings vehicle instead of an all-purpose investment account.
Indexed annuities offer market-linked returns but limit your earnings if the stock market performs well. This “cap” restricts your annuity’s returns to a specific amount, while most other investment accounts don’t.
Life Expectancy Challenges
Annuities that provide payments for life are based on actuarial tables that estimate average life expectancy. If you live longer than the average, you may receive more payments, but if you pass away early, you don’t reap the benefit of receiving years of distributions. In addition, your heirs won’t receive a penny unless your annuity has a death benefit rider.
No Step-Up for Heirs
Upon the death of the annuity holder, heirs may not receive a stepped-up cost basis for tax purposes. The unfortunate result is that any gains in the annuity are subject to capital gains tax when your heirs receive the funds.
No FDIC Insurance
The Federal Deposit Insurance Corporation (FDIC) doesn’t insure annuities like it covers bank accounts. While annuities sometimes have backing from your state guaranty association, that coverage isn’t consistent and might be lower than the FDIC coverage of $250,000. Lack of coverage means you’re at the mercy of another company scooping up the accounts if your annuity company goes under.
Annuities can offer unique advantages, providing a reliable source of income, product flexibility, tax benefits and a potential hedge against inflation. However, their drawbacks include overwhelming complexity, fees, lack of liquidity and tax penalties for early withdrawals. You should carefully evaluate your individual financial situation and consult a fee-only financial planner to determine if an annuity is the right investment for you. Remember, taking the time to make an informed decision ensures that your financial plan remains on the right track.
Tips for Evaluating Annuities
- Shopping around for annuities can leave you confused about how each one works. Fortunately, a financial advisor can decipher these contracts and give insight on how they align with your retirement plan. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before you decide on an annuity, it’s helpful to know what expenses you’ll have in retirement. Then, you can create an investment plan to ensure you have enough during your golden years. Use SmartAsset’s free retirement calculator to project your earnings and expenses in the future.
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