Annuities are investment vehicles that are designed to offer a stream of income for a specified period of time. Annuities have a number of benefits including a guaranteed income for life and tax-deferred growth. This article will cover 6 disadvantages to be considered before owning an annuity.
- Receipt of a lump sum (either at retirement, or to a beneficiary at death) could result in a significant tax burden because income averaging is not available (however, planning can moderate this if the proceeds are annuitized).
- The cash flow stream of a fixed payout may not keep pace with inflation, particularly for longer-term payout phases such as a life annuitization.
- Annuity owners generally incur a 10 percent penalty tax on withdrawals of accumulated interest during the accumulation phase prior to age 59½, unless the annuity owner is disabled (this may also apply to the annuitization phase if the annuity was not an immediate annuity and the owner selected certain short payout terms).
- With a few limited exceptions, annuity contracts held by corporations or other entities that are not natural persons, are not treated as annuity contracts for federal income tax purposes. This means that income on the contracts for any taxable year are treated as current taxable ordinary income to the owner of the contract regardless of whether or not the owners make any withdrawals.
- If the client is forced to liquidate the investment in the early years of an annuity, management and maintenance fees and sales costs could prove expensive. Total management fees and mortality charges can run from 1 percent to 2.5 percent of the value of the contract (occasionally as high as 3 percent in the case of variable annuities with a number of underlying guarantees). Most insurers charge a back-end surrender charge if the owners terminate contracts within the first few years after purchase to compensate the insurers for the sales charges that they typically do not levy up front.
- Owners are taxed on investment earnings at the owners’ ordinary income tax rates when the owners receive payments, regardless of the source or nature of the returns. Consequently, investment earnings attributable to long-term capital appreciation (typically in variable annuities) do not enjoy the more favorable long-term capital gain tax rate that otherwise generally would apply. This has become even more disadvantageous in recent years with the reduction of the maximum long-term capital gain rate. Furthermore, investment earnings attributable to dividends on stocks that would qualify for the 15 percent maximum tax rate if the stocks were held outside an annuity also are taxed at the owner’s ordinary income tax rate (although owners/annuitants will not be taxed on these dividends until they receive payments). Consequently, variable annuities—where the annuity owners, generally, are more inclined to invest in equities under a tax regime of lower capital gains and dividend tax rates—have been much less attractive than previously.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM