Certified Safe Money Admin
Certified Safe Money Admin
Annuity Risks – Costly Annuity Mistakes to Avoid
With the near disappearance of traditional employer-sponsored defined benefit pension plans today, more people are turning to annuities so they can create a reliable retirement income stream. But, while an annuity can certainly provide you with lifetime income, these financial vehicles can also have a lot of “moving parts.” It is important to understand that there could be some costly annuity mistakes to avoid before moving forward.
Annuities are Not Liquid
One of the costliest attributes about annuities is their surrender fees – and just about every annuity includes these charges if you take “too much” of your money out early. Insurance companies that sell annuities want to make sure that the contracts are held for at least a certain amount of time.
Surrender or withdrawal charges can be incurred if you cancel the annuity within a given amount of time (usually anywhere between three and twelve years, depending on the annuity). In fact, in most cases, even if you withdraw more than 10% of the annuity contract value in a given year during the surrender period, you will typically be charged a surrender fee.
You can also be subject to income taxes on an annuity withdrawal on the portion of the money that is considered gain. In addition, if you make such withdrawals before you have turned age 59 ½, you could also incur an additional 10% “early withdrawal” penalty from the IRS.
So, before you commit to buying an annuity, you need to be aware that doing so is a long-term prospect and that you don’t use funds that you may need to access for emergencies or other obligations any time soon.
Something That’s “Too Good to Be True” Usually Is
Some annuities are marketed as offering the “best of all worlds.” Take, for instance, fixed index annuities (FIAs). These types of annuities offer the opportunity for growth in an upward moving market, as well as principal protection – even if the index being tracked performs negatively during a given time period.
But, while these are undoubtedly enticing features, there are also some “tradeoffs” that you need to make to receive these benefits. For instance, in return for the protection of your money in a down year, most indexed annuities will impose a “cap” on the positive returns.
For example, if there is a cap of 5%, and the tracked index has a 15% return in a given contract year, the annuity will only be credited with 5%. Plus, as referenced above, annuities are long-term commitments. Therefore, even if the product is performing well, if you access your money “too soon,” you will have to pay the price through a surrender fee.
Annuity Bonuses Can Sometimes Backfire
Some annuities offer a premium “bonus” when you make contributions. But even though “free money” sounds nice, there is actually a cost for this benefit. In this case, you generally have to hold on to the annuity for a certain period of time. Otherwise, you will lose the bonus, as well as any of the interest that was credited on it.
On top of that, annuities that credit a bonus to the account may also offer low rates of return – particularly in the later years of the contract. With that in mind, make sure that you compare the expected overall returns between a “bonus” annuity and another that offers a higher interest rate on the contract.
Income from Annuities is Not Typically Tax-Free
Annuities are often touted as having tax-related benefits. But, while the money that is inside of an annuity is allowed to grow on a tax-deferred basis, withdrawals are typically taxable. How much of the income is taxed will depend on how the annuity was funded.
For instance, if you were buying an annuity with after-tax dollars, then only a portion of the income payment – the part that is considered gain – will be taxed as ordinary income. However, if you purchase an annuity with pre-tax dollars (such as via a traditional IRA or 401k rollover), then 100% of the annuity income payment will be taxable.
As an added precaution about annuity withdrawals’ taxation, it can be difficult to determine how much annuity income you will actually have available to spend without knowing what future income tax rates will be.
Not All Annuity Rates are the Same
If you’ve been researching annuities, it is likely that you have come across a plethora of different “rates.” For instance, annuities can possess interest rates and withdrawal rates, cap rates, and participation rates.
One of the biggest of the costly annuity mistakes to avoid is getting these rates confused and then being disappointed when the contract does not perform as you anticipated it would. With that in mind, be sure to discuss any and all annuity rates with your retirement financial advisor before committing to a purchase.
Look Out for Limitations on Growth
Not all annuities are exactly the same. So, depending on the type of annuity, you could run into various limitations on the growth. As an example, in return for protecting your principal from a downward moving market, fixed indexed annuities will typically limit the upside potential using caps, participation rates, or spreads.
While caps will limit the amount of interest you receive – even if the underlying index has stellar performance in a given year – participation rates will limit the percentage of the return the annuity is credited.
For instance, if an annuity imposes a participation rate of 80%, and the underlying index returns 10% in a given year, then the annuity will be credited with 8%. That’s because 80% of 10% is 8%.
Similarly, spreads – which are oftentimes referred to as “margin fees” – can reduce the overall return that is credited. In this case, if an annuity includes a spread of 5%, and the index increases by 12% in a given period, then the annuity would be credited with 7% (because 12% – 5% = 7%).
Given all of these potential growth limitations, it is essential that you understand how each works and how it could help or hinder the ultimate performance of the annuity going forward.
Also, make sure that you are aware of how long cap rates, participation rates or spreads will remain the same because, in some cases, the insurance company has the right to change the amount(s).
Therefore, if an annuity that you are considering has a relatively high cap, it is possible that the percentage could be decreased down the road, severely hindering the amount of return that your annuity is eligible to receive.
How to Avoid Costly Annuity Mistakes
Annuities can be loaded with lots of “fine print.” So, while these financial vehicles can definitely provide you with some great guarantees like lifetime income, you will want to know what you might have to give up in return for that.
Discussing your short- and long-term financial objectives with a retirement income planning professional can be beneficial, as they can help you with sorting out your options, and point out both the advantages and the potential drawbacks to you before you make an “expensive” commitment.