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Annuities: Who Needs Them?

"Pssst. Hey, buddy. Can I offer you some tax-deferred growth?"

If you've ever been advised to use an annuity to save for retirement, then you've heard that line (or some variant thereof). In fact, you may have heard it over and over from the person trying to sell you the annuity. There are many reasons not to invest in such things; the salesperson has to overcome all objections with the promise that you won't give so much to Uncle Sam.

But with tax rates the lowest in decades, how important is tax-deferral? We'll address that question later. First, let's start with the basics.

What's a tax-deferred annuity?
While considered investments, annuities are technically insurance products. There are many types of annuities -- a confusing array, actually, which is another reason to tread carefully -- but it essentially comes down to two broad categories: the type that pays a lifetime of income to retirees, and the type that people use to save for retirement while they're still working. They're really two different beasts that have confusingly been given the same name. In this article, we'll discuss the latter -- the annuity as a retirement-savings vehicle.

The easiest way to think of this type of annuity is as a mutual fund (or funds) wrapped in an insurance policy. That "wrapping" bestows tax-deferred status on those funds, which means the investor won't pay taxes on the investments as they (hopefully) grow through the years, but will pay taxes on money that is withdrawn.

That sounds great. But in reality, you'd be hard-pressed to find someone who is a big fan of annuities other than the people who sell them (for big commissions, we must add -- usually bigger than the commissions associated with sales-loaded mutual funds). What's wrong with tax-deferred annuities? Let us count the ways:

  • That insurance "wrapping" costs money -- usually around 1% of the account value each year. Couple that with expense ratios on the investments in the subaccounts (which is what they call mutual funds within annuities) and 2.5% a year could be lopped off your return each year.

  • All the insurance does is guarantee that, upon your demise, your heirs will receive at least the amount of money you invested in the annuity. So, theoretically, you don't have to worry about a market crash right before your death. Some policies will augment this benefit, for a price. For example, the "death benefit" might automatically increase 5% a year. But assuming the investor chose the annuity as a long-term investment (as any retirement investment should be), how likely is it that an account wouldn't have grown over, say, a decade or two?

  • Most annuities impose "surrender charges" that penalize policyholders who pull out of the annuity within a specified number of years. Typically, the penalty is 7% if the policy is cancelled within the first year, 6% the second year, 5% the third, and so on until the surrender charge vanishes.

  • While growth in an annuity is tax-deferred, contributions are not tax-deductible -- unlike contributions to your work-sponsored retirement plan. Investors should always max out their 401(k)s and any IRAs they're eligible for before considering an annuity.

  • Like other retirement accounts, if you withdraw money from an annuity before you're 59 1/2, you'll pay taxes and penalties. There are a few ways around this, but, generally, the majority of your money will be tied up.

The tax "advantages"
"Who cares about all that?" Mssr. Annuity Salesman says. "You get tax-deferred growth!"

That is true -- but it doesn't mean you'll pay less in taxes. Why? Because a payment from an annuity is considered ordinary income and will be taxed at your marginal rate (also known as your tax bracket). For most of us, that is 25% to 35%. Compare that to the tax treatment of dividends and long-term capital gains, which are taxed at a maximum of 15%.

So which will get you higher after-tax retirement income: an annuity, which allows you to save on taxes today but pay at a higher rate in retirement, or investments in a taxable account? The answer relies, of course, on several factors.

First of all, investors should compare their tax bracket now with what they expect it to be when they retire (a tenuous exercise, we know). The higher one's rate is now relative to in retirement, the better an annuity looks since taxes will be deferred in higher-tax years and paid in lower-tax years.

Secondly, an investor's timeframe until retirement is important. The farther away from the golden years, the more time an annuity has for its tax benefits to overcome the higher expenses. Most experts used to say that it takes an annuity 15 to 20 years to be a worthwhile investment. But with the new, lower tax rates, it might take an additional five years for an annuity to really pay off.

Thirdly, and perhaps most importantly, investment habits dictate the usefulness of an annuity. Here are the two extremes:

1. The buy-and-hold index investor: This person plans to hold on to his index fund or exchange-traded fund (ETF) for decades, not selling -- and thus not incurring capital gains -- until retirement. Yes, these investments spin off dividends and occasional capital gains distributions (though gains distributions with index funds and ETFs are comparatively paltry). But such liabilities may not be as bad as the higher expenses and deferred higher tax rate of annuities.

2. The actively managed fund day trader: This person doesn't stick with a mutual fund for long. And every sale is a taxable event. (Of course, it might be a capital loss -- which can be used to offset gains, a strategy not available to annuity holders.) Plus, choosing actively managed funds increases the chances that the fund will distribute capital gains throughout the year. Such an investor might be better off with an annuity -- and a therapist.

Then again, maybe you should get an annuity
Chances are, you're somewhere in the middle of the two. And, truth be told, there are companies -- such as Vanguard, TIAA-CREF, and T. Rowe Price (Nasdaq: TROW  ) -- that offer low-cost annuities and don't levy surrender charges. For example, the average annual expense on a Vanguard annuity is 0.63%, including insurance and investment management fees.

And while the tax rates on long-term capital gains and dividends are low, the laws that lowered them will "sunset" at the end of 2008. In other words, unless Congress acts, rates will go back up to previous levels in 2009. It's very difficult to base long-term plans on tax policy since it changes so often.

So, if you're in the 25% tax bracket or higher; have maxed out your other tax-advantaged retirement accounts, such as your 401(k) and IRA; don't tend to be a buy-and-hold investor of tax-efficient mutual funds; and are at least 15 years from retirement, then maybe an annuity fits into your plan. But those are a lot of "ifs."

For more on adding shine to your golden years, check out these 7 ways to retire.

Robert Brokamp has an IRA and a 401(k), and knows the words to "Do-Re-Mi." The Motley Fool is investors writing for investors.


Read/Post Comments (2) | Recommend This Article (9)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 12, 2009, at 7:18 PM, sonic1us wrote:

    As an annuity sales guy I couldn't help but laugh at your "article". First off, annuities are even close to mutual funds inside insurance. Secondly, your description of the annuity otherwise is totally off track. Finally, since you wrote this in 05 thinking the market was safe how do you like us now!?

  • Report this Comment On October 28, 2010, at 1:20 AM, jstbook wrote:

    -Most annuities are lifetime contracts which mean you would receive paychecks as long as you live. This will give you peace of mind because you need not fear that you will outlive your income.

    -Inflation can have a devastating effect on your finances. Fixed annuities protect you from inflation. The money you receive will keep up with the cost of living. This assurance of safety comes for a price though. Either your starting payments will be low or the initial investment cost will be higher. <a href=http://annuityratesinstantly.com/instant-annuity-rates>Ge... Best Annuity Rates</a> from our website.

    -One of the best features of annuities is principal protection. It is guaranteed that you or your successor will get back at least the amount of money which you invested in the annuity. To ensure this it is obligatory for the companies to keep cash reserves. Many states have a guarantee fund of $100,000 in case the company becomes insolvent.

    -Annuities are virtually life insurance policies. So you can nominate beneficiaries. Also, probate can be avoided when beneficiaries are declared.

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