Annuity Advantages & Disadvantages
- Annuities that provide an immediate stream of payments are called "immediate annuities," while annuities expected to begin delivering regular payments in the future are called "deferred annuities." Contracts that guarantee a fixed, specific rate of return are called "fixed annuities," and contracts that allow the investor to assume market risk by directing investments into sub-accounts focusing on stocks, bonds or other asset classes are called "variable annuities." Another type of annuity, called an equity-indexed annuity, guarantees a minimum return over time but also links annuity returns to the performance of an index. If the index goes up, the insurance company credits the annuity with a portion of the gain. If the index is flat or falls, the annuity owner still gets the minimum guaranteed return over time.
- Annuities grow tax-deferred, and you can make unlimited exchanges between variable annuity sub-accounts without generating a capital gains tax liability. You can also make unlimited exchanges between annuity contracts under Section 1035 of the Internal Revenue Code without generating a tax bill. If you have life insurance, you can also conduct a Section 1035 exchange into an annuity with no taxes due; if you tried to exchange the life insurance policy for anything other than an annuity or another life policy, the IRS would charge taxes on any gains.
The IRS taxes a portion of annuity income at ordinary income tax rates. This could be a disadvantage to taxpayers in higher tax brackets, since long-term capital gains rates are likely to be lower for them than income tax rates. However, except for annuities in retirement accounts, the income tax only applies to a portion of the annuity income. - If you take a lump sum out of an annuity prior to age 59 and a half, the IRS will charge you income tax, plus a 10 percent excise tax for early withdrawal, similar to the penalty for IRAs and 401ks. Annuities will typically charge a "surrender charge" if you withdraw or transfer money within a certain amount of years -- typically five to nine years. Some annuities, however, will pay a "bonus," designed to offset the surrender charge, to help entice customers to transfer money into their annuity products. Other assets, such as mutual funds, stocks and bonds, do not charge surrender charges directly. However, it costs money in commissions to buy and sell these assets, except when you buy from a no-load mutual fund company or through a retirement plan.
- Annuities offer a number of guarantees not available from other kinds of assets, including a guaranteed stream of income for life, or the life of you and one other person, such as a spouse or grandchild. Annuities can also guarantee a minimum withdrawal benefit and a minimum death benefit, or periodic "resets" to the highest balance achieved by the annuity, regardless of market performance. These guarantees are frequently available as "riders," or optional features. The more riders, the higher the annuity's annual expenses, expressed as a percentage of assets charged against the annuity balance, are likely to be.
- Mortality credits are the "bonus" earned by annuitants who live longer than the average annuitant. When an annuity pays a guaranteed income for life, the premiums paid by annuity owners who die early go to those who live longer than actuarially expected. As a result, the lifetime income annuity can guarantee a much higher income for a given investment than CDs, most bonds, or other investment vehicles. However, the annuitant gives up control of and access to the money.
