2 May 2014 0 Comments

Potential Pitfalls of Deferred Annuities – Part Two

shutterstock_157383680In Part One of this discussion on the potential pitfalls of Deferred Annuities I mentioned Surrender Charges.  Surrender charges are imposed to compensate insurance companies for the commissions and other acquisition costs they incur when a Deferred Annuity is purchased.  If the annuity stays in force long enough, these costs can be amortized over the anticipated life of the annuity.  Typically surrender charges start at about 7% and decrease each year the contract stays in force, reaching zero at the 7th year.  If they extend much beyond that point it most likely indicates a higher commission than normal and is reason to question the agent.

Now, here are some other things of which to be aware:

Tax Penalty

If you make withdrawals from a Deferred Annuity before the year in which you turn age 59 ½ there will be a 10% penalty tax added to normal ordinary income tax due on the gain.  It’s possible to avoid this penalty if the withdrawals made are calculated to equal the level amount required to deplete the annuity’s value at life expectancy.

No Capital Gains Treatment

When you make cash withdrawals from a Deferred Annuity, all gains are taxed as ordinary income; there is no capital gains treatment of earnings.  This is irrelevant for Fixed Annuities whose funds would otherwise have been in an interest bearing account such as a bank CD with earnings also subject to ordinary income tax.  However, money used to purchase Variable Annuities would likely have been invested in mutual funds or stocks whose earnings could have qualifies for the lower capital gains taxes.


Excessive Loads

A Variable Annuity is similar to Mutual Funds with all tax deferred until withdrawal.  Besides the loss of capital gains taxation mentioned above, the loads imposed by a Variable Annuity exceed by 1% to 2% the management charges imposed by a Mutual Fund.  This equals about a 50% or greater increase in loads.

Is Bonus Interest Really a Bonus?

Often Fixed and Indexed Annuities will promote that they credit bonus interest.  They might well do that, but there is always a requirement to qualify.  Often, the interest is only available if funds are held for a minimum number of years with no withdrawals taken and then the bonus only applies if funds are accessed through a fixed payment spread over a minimum time period.  The bonus isn’t bad, just understand how it works.

With today’s low interest environment, by far the vast majority of new Deferred Annuities being purchased are Variable or Indexed.  Interest rates on traditional Fixed Annuities may compete with bank CD’s, but if rates rise, a long surrender charge can make it costly to move to a higher interest crediting policy.  Indexed Annuities provide a viable option for those who look for safety of principle, with the possibility of exceeding today’s low interest rates, while avoiding current taxes.  Indexed Universal Life is also an option for those looking for a tax-free retirement supplement and family protection who have at least 10 years to save before retirement.

Determine your goals, define your investment acumen, find an independent agent with whom you can communicate and Annuity and Insurance policies can be an attractive part of your financial objectives.

Next…special life insurance considerations if you are a smoker.

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