If you are at the doorsteps to retirement, you might regularly receive invitations to enjoy a free lunch/dinner as part of an “educational” seminar on various retirement, estate planning, or trust topics. Often these invitations are made extra enticing by featuring a fancy restaurant for the presentation. Yet as the saying goes, few of us believe these meals/events are without any strings attached; we know there will be some “catch” or pitch of a product or service.
One topic we regularly encounter with new clients approaching us for help is in the area of annuities. While there are advantages and disadvantages to these complex products, in our experience, they are often sold without full and adequate explanation. While we prefer and advocate the use of more customizable, and traditional investment structures (wherein you retain full control of your time horizon, investment options, and access to money), we would stop short of saying or suggesting that annuities are never appropriate. So let’s objectively review one of the most misunderstood financial products available.
- Annuities create a tax-sheltered structure for which assets/investments can appreciate in value without being subject to current interest, dividends, or capital gains taxes.
- Annuities avoid probate and account values are paid direct to beneficiaries at death.
- Annuities can provide a guaranteed monthly income.
- Most contracts are subject to initial loss of access to your principal in the first 7 years (on average) called surrender penalties.
- Some annuities (especially variable) have significant annual fees and expense structures, which are not always properly disclosed
- Investment options and features may be complicated.
- As an annuity account grows tax deferred, withdraws are sourced from accumulated earnings first and treated as ordinary income just like distributions/withdraws from your 401k and IRA.
- 10% Penalty (in addition to tax on earnings) applies to withdrawals before age 59 ½.
While annuities are conceptually appealing on the surface, as Paul Harvey said, ”Now for the rest of the story”. Usually not understood is that the growth – combination of interest, dividends, capital appreciation is taxable as ordinary income upon withdraw. This tax treatment causes many people to ultimately feel like money accumulated in personal annuity contracts is less flexible/accessible than if it were held in a traditional personal brokerage account. When considering participation in retirement accounts (IRAs, 401k/403b, etc.) and including annuities, one can find themselves over-loaded into tax deferred accounts which could create a ticking “tax bomb” and lack of asset flexibility.
Many individuals in retirement defer taking withdrawals due to the tax treatment on appreciated annuity contracts. As a result, we see the next generation inherit a “tax bomb” surprise. If instead they invested their savings into a personal brokerage account, their inheritance would receive a step-up in basis at the death of the owner (such that non-spouse beneficiaries would inherit assets without a significant tax implication).
Long story short: annuities are complicated, and do not offer a free lunch or magic bullet – a mantra that seems to apply to most any and all areas of life. Understanding the full story, and in the case of annuities their attributes and tax treatment is important when giving consideration to asset location and/or the order of withdraws needed by elderly loved ones. Keep in mind, many annuity features/attributes can be achieved or produced via traditional investment account structures. In addition, there are strategies that can convert money accumulated inside of annuity contracts into other products/assets (such as long-term care for example), that may be more beneficial and tax efficient to both contract owners and their beneficiaries. Don’t hesitate to ask us to review any annuity contract that you or your family own at an upcoming meeting; we will offer you an objective analysis, opinion and options.