McKee Investment Planning

The Truth About Annuities

Annuities have taken the investment world and investors by storm. Sold with catch phrases such as "guaranteed" and "tax deferred", billions of dollars are plundered in these products each year. This marketing scheme has left many investors with a false sense of security while making insurance companies and salesmen rich.

When you buy a variable annuity, the insurance company invests your money in mutual funds (fixed annuities use bonds) and then charges you an additional annual expense for various "insurance" features on the underlying investments. You pay both the expenses of the investments and the additional expenses of the insurance.

Here's what they don't tell you....

Why You Can't Get Your Money Back Without Penalties

When you bought your annuity, the insurance company paid the broker/agent a large commission, usually 5 to 10% of the purchase price. The insurance company needs to keep your money in their accounts so that they can charge you high fees over many years to recuperate the commission paid. You'll never actually see the fees on your statement. They are deducted from the "sub-accounts" and can't be found on your statement.

If you "surrender" or withdrawal your money prior to the prescribed waiting period, the insurance company charges you an early surrender fee to cover the expense of paying the broker/agent. Most annuity contracts base the penalties upon the number of years since the contract was bought. For example, if you withdraw your money within the 1st year the penalty would be 7%, 2nd year would be 6% and so on.

Note: The surrender penalty is not the 10% IRS penalty for pre - 59 1⁄2 early withdrawal from an IRA. If your annuity is an IRA, and you are under 59 1⁄2, the surrender penalty would be in addition to the IRS penalty.

The "guarantees" that annuities promise are, in virtually all cases, only valid if you die while owning the annuity. This is because the insurance feature of an annuity involves annually renewable term insurance on your life. If the underlying investments in the annuity lose money, and you ask to take out the "guaranteed amount" you will be sorely disappointed.

Taxing The Beneficiaries

When your heirs recieve the account, annuities are very tax burdensome. Without any step-up in cost basis, and with all gains taxed at marginal income tax rates, there is not much room left for tax planning. Generally speaking, when parents die, their "children" are already in a high tax bracket. Having to give the IRS 35% of their parents' life savings is an unpleasant and unwelcome surprise.

Reducing Returns

Annuity contract expenses are generally two-to-three times higher than what you would normally pay to invest directly in the mutual funds (variable annuity) or bonds (fixed annuity). For example, if your mutual funds earned 10%, your annuity, invested in the same mutal funds, would only increase by 7%. If your mutual funds stayed even at a 0% return, your account would decrease by 3%.

The Bottom Line

Don't get "sold" on annuities. If your objective is to earn the highest possible return on your investments, have access to your money if and when you need it, and protect your heirs from unwanted tax liabilities, then you should invest directly in the right mutual funds and bonds.