Annuities 101

With so many types of annuities offered -- and a complex array of rules, fees and restrictions -- it's not uncommon for investors to buy products that aren't ideally suited to their needs.
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Nervous investors seeking safe havens have faced many daunting challenges over the last few years. The stock market's rollercoaster ride, plummeting housing values and extremely low savings account and CD interest rates have whittled away at their ability to save and find protection from inflation.

That's one reason why many people approaching retirement or already retired turn to annuities as a guaranteed steady source of income. But with so many types of annuities offered -- and a complex array of rules, fees and restrictions -- it's not uncommon for investors to buy products that aren't ideally suited to their needs.

Here's a brief primer on how annuities work and what to watch out for:

An annuity is an insurance product you purchase that pays out income. Typically, you make a lump-sum payment or series of payments to the seller -- often an insurance company. In return, that company agrees to make periodic payments to you for a definite period (say 10 or 20 years) or an indefinite period (until death) in one of two ways:
  • Immediate annuities begin paying benefits the year you deposit your money. Your payment amount is based on factors such as how much you invest, your age and gender.
  • With deferred annuities, you contribute either a lump sum or monthly installments and your account grows on a tax-deferred basis (see "Tax implications" below) until you begin receiving payments at a later date.
There are three basic types of annuities:
  • Fixed annuity. The seller agrees to pay you no less than an agreed-to rate of interest while your account is growing and to make periodic payments of a specified amount. Note: Fixed annuity payments do not increase to keep pace with inflation.
  • Indexed annuity. The seller provides an investment return based on changes in a particular index, such as the S&P 500. Indexed annuities also stipulate that the contract value will be no less than a specified minimum, regardless of how the index performs.
  • Variable annuity. You choose how your account is invested from a variety of options -- typically mutual funds. The rate of return on your deposits and the amount of the periodic payments you eventually receive will depend on the performance of the investment options you select. Thus, although variable annuities have greater growth potential in the long run compared to fixed annuities, in a poor market your payment could actually decrease.
  • Some immediate annuities attempt to keep pace with inflation by investing in such securities as the Treasury Department's Treasury Inflation-Protected Securities (TIPS); however the initial payments for these products are often much lower so it may take several years before you see a difference.

Tax implications. One reason many people purchase annuities is because their account grows tax deferred -- that is, when you eventually do receive payments, your contributions themselves are not taxed, but any earnings they generate are taxed at your regular income tax rate. Unlike other tax-deferred retirement accounts, such as 401(k) plans and regular IRAs, annuities have no annual contribution limit. However, as with those other accounts, you'll pay a 10 percent federal tax penalty on money withdrawn from an annuity before age 59 ½.

One big tax disadvantage with annuities is that unlike money invested in stocks, bonds or mutual funds, whose earnings are taxed as capital gains (current rate is 15 percent) when sold if held longer than one year, annuities are taxed at regular income tax rates, which can be significantly higher for people in higher tax brackets.

Fees and expenses
. The main drawback to annuities is that they can be very expensive compared to other types of investments. Among the expense factors to investigate before signing any agreement:
  • Commissions. Many annuities are sold by sales people who earn commissions as high as 10 percent for your initial investment, plus ongoing commissions in subsequent years.
  • Annual fees. Depending on what type of annuity you buy, you could be charged an additional 2 percent or more per year in various account management fees.
  • Surrender charge. Most deferred annuities charge an early withdrawal penalty known as a "surrender charge." Surrender charges usually start at 7 or 8 percent of your investment and decline to zero over the next six to eight years. However, they can range up to 16 percent and last for as long as 15 years, so read your contract carefully.
Some investment companies sell "direct-sold" annuities, where no insurance agent is involved so there is no sales commission or surrender charge. Firms that sell low-cost annuities include Charles Schwab, Fidelity, Vanguard, T. Rowe Price, Ameritas Advisor Services and TIAA-CREF. A few additional precautions:
  • When seeking annuity investment advice, you may want to consult a fee-only financial advisor (versus one who earns commissions on products he or she recommends).
  • Because 401(k) plans and IRAs are already tax-deferred and their fees are usually much lower, it may not make sense to roll over those balances into an annuity. Ask your financial advisor to crunch the numbers.
  • Before moving an existing annuity into a new account, analyze surrender charges, sales commissions and other fees you'll be charged (including a possible 10 percent tax penalty if you're under age 59 ½) to ensure it's worth making the change.
  • Many annuities end upon your death, so if you want your heirs to continue receiving your benefit, investigate joint and survivor or term-certain annuities (these will likely increase fees and/or reduce the benefit amount).
  • Because payouts can vary widely, it pays to comparison shop among several reputable insurance companies.
  • If the insurer selling you an annuity happened to go out of business, you could lose your money. So check the insurer's credit rating with credit bureaus like A.M. Best, Standard & Poor's and Moody's.

To learn more about annuities, visit investor websites for the Securities and Exchange Commission and the Financial Industry Regulatory Authority.

Bottom line: For many people, investing a portion of their money in annuities is a good way to diversify investments and guarantee a steady source of income in retirement. But make sure you fully understand the terms, cost structure and possible penalties before you sign on the dotted line.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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