There are two main types of annuities: fixed and variable. What's the difference?
- Fixed annuities earn a stated annual rate of return paid by the insurance company for a specific period. Even with a fixed annuity the rate may change at each year if the insurance company chooses.
- Variable annuities, on the other hand, give investors the opportunity to get the higher rates of return from investing in the stock market. But that also means getting lower returns when the market goes down.
Insurance companies that sell variable annuities invest your premiums in mutual fund-like investments. The amount you receive back changes based on how well those investments perform. You usually can choose where you want your money invested from a list of mutual funds the insurance company offers.
Is Investing in a Variable Annuity Right for You?
Variable annuities may sound good, but you need to look behind the promotions to determine whether such an investment is right for you. The older you are, the less likely a variable annuity will be right for you. Before investing in a variable annuity contract, be sure to investigate and understand two very important issues - risk and costs.
- If you have to count on receiving monthly payments in the future, is the risk of fluctuating payments that go along with a variable annuity appropriate for you?
- Do the benefits of an annuity as an investment option justify the costs?
High Commissions. The insurance agent, broker, or banker who sells you a variable annuity will generally earn a commission of 6% to 10% on the money you invest. For example, if you invest $100,000 in a variable annuity, the salesperson will get a commission of $6,000 to $10,000. This will reduce your $100,000 before any investment is made. Be sure you know how much commission is deducted from your contribution, so you can compare it with other investment options.
Tax Benefits Now and Then. A big selling point of the variable annuity is that you don't have to pay income tax on any earnings until you withdraw funds or start to receive payments. However, when you start making withdrawals your earnings will be taxed as ordinary income. Depending on your tax bracket at that time this could be between 10% and 35%. You lose the opportunity to pay the lower capital gain or qualified dividend rate of 5% or 15% that you pay on other investment income. So the benefit of income tax being deferred now may be offset by the higher tax rate that you would pay later. You need to determine if the difference in taxes you pay on a variable annuity versus a mutual fund that you invest in directly is important to you.
Guaranteed Principal. Many investors are attracted to the guarantee that the original principal amount will be returned even if the annuity investments have lost value. Unfortunately, with most contracts this guarantee for 100% return of the principal is only available if the owner dies before the end of the contract. If you want this guarantee of the principal, you have to pay an additional annual expense, called the "mortality cost." According to Morningstar, the average annual fee to get this guarantee is 1.35 % of assets.
Negative Impact to Beneficiaries. If your children or grandchildren receive stock or mutual funds as part of their inheritance, they receive a "step up" in the basis of the investment. This means that all capital gain is eliminated for your heirs. An annuity does not receive a "step up" in basis. Instead, your heirs will have to pay ordinary income tax rates on all payouts they receive from your annuity.