Annuities
Annuities are products provided by insurance companies with special tax and insurance benefits. Annuities usually bundle a variety of investment choices, called subaccounts, that bear a resemblance to mutual funds. The earnings and investment profits in the annuity aren't taxed until they're withdrawn. When you do make withdrawals, you pay income tax on the amount you take that is over and above your original deposit. This doesn't matter whether the earnings were from capital gains or from interest earned by the investments within the annuity. Your investment in the annuity is only as secure as the insurance company itself; be sure to check the financial-strength ratings of the insurance company you're considering.
My annuity is six years old and has performed poorly. How do I calculate the fees to close the account?
The prospectus lists the percent fee for withdrawal during each year. Check the annual fee, too. If it is the same as the year-six withdrawal fee, it might be worth closing the account without waiting another year.
Annuity Features
There are two phases in the life of an annuity — the accumulation phase and the payout phase. During the accumulation phase, the investor makes one or more deposits into the annuity. During the payout phase, the annuity makes payments back to the investor and, if directed, the investor's beneficiaries for a specific period of time.
Investors like annuities because the insurance company invests the money and promises an income payout for a specified duration of time. That time period could be for a set number of years — called a “term certain” — or for the investor's entire life — “lifetime income.” The regular amount paid for lifetime income is lower than that paid for term certain in most cases, but the marketing appeal of income for life is very powerful. Be extra sure you review the payout options on your annuities very carefully to see which would work best for you.
Annuities are also used by governments and private entities to provide pensions, and there are a few very low-fee annuities like those provided by TIAA CREF — Teachers Insurance and Annuity Association, College Retirement Equities Fund — that have successfully accomplished what they have promised. Unfortunately, too many annuities are purchased by people who don't fully understand how complex and expensive they can be.
Annuities generally carry higher fees than mutual funds because of their insurance features. This insurance feature is what created the higher-cost tax characteristics of annuities. The benefit offered is that beneficiaries might receive more than the value of the account if the investor dies and certain requirements are met. The disadvantage is that recent tax laws have made the payments from annuities more expensive by being taxed as income rather than lower-rate capital gains.
Immediate and Deferred Annuities
Annuities that start the payout phase immediately after one deposit are called immediate annuities. Deferred annuities start paying after an accumulation phase and accept deposits over time. You may never decide to annuitize a deferred annuity — meaning to start taking payments. Many investors hold the deferred annuity like any other investment account and then plan to take periodic withdrawals when needed in the future. Annuities can be changed just like other investment products. You can sell your annuity and buy another — a tax-free transaction called a 1035 exchange. Or you can withdraw the money from your annuity and reinvest or spend the funds. The amount of your withdrawal above and beyond the amount you deposited is taxable as income. If you withdraw money from your annuity before you turn age 59½, you may also have an early withdrawal penalty of 10 percent.
Fixed and Variable Annuities
Annuities that are invested by the insurance company and earn interest are called fixed annuities. Be careful: the back-end sales charge on an annuity can make moving the account within seven years expensive. Many fixed annuities carry higher interest rates for the first year, with subsequent years being paid lower interest. The fees may make moving to another account quite expensive.
Variable annuities have subaccounts that invest in stocks and bonds like mutual funds. There are also new annuity products called equity-indexed annuities. In both cases, investors are seeking to earn returns similar to the stock market. Annuities have become a less desirable way to do this because you're shouldering all the same risk of investing in stocks without the lower-rate capital gains tax benefits. Equity-indexed annuities have become controversial because they seem to offer the chance at stock market returns without the stock market risk by promising a minimum annual return. Many investors have bought these complex investments without realizing that, after fees and expenses and tax charges, they have fared worse than if they had invested outside of the annuity.
