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Annuities: A Field Guide

Technically, an annuity is simply a stream of payments. The military retirement pension, in this sense, is an annuity. But when we talk about financial products, an annuity has a much more specific meaning: It’s a contract. That’s it. You pay the insurance company a certain amount of money, and they promise to provide you with a stream of income – either starting now (an immediate annuity) or at some time in the future (a deferred annuity).

In its most basic form then, an annuity is a promise from an insurance company to pay you a certain amount of money, every month or every year.

You can use an annuity contract to guarantee yourself a stream of payments in retirement that you can never outlive. You contribute a lump sum, and the insurance company figures out your life expectancy, and guarantees, in writing, that they will pay you a specific amount of income no matter how long you live.

This is a valuable thing to be able to have in retirement, because it helps you eliminate longevity risk – the financially devastating possibility that you will run out of retirement savings while you are still alive.

You can also trade a lump sum for a period certain annuity: The insurance company guarantees you a certain income over a certain period of time.

The longer the period you project you will receive payments, the lower the payment will be.

With a deferred annuity, you contribute premium to the insurance company, and they credit you with either a guaranteed interest rate (for fixed annuities), or you can invest in a variety of subaccounts that track various asset classes, such as stocks or bonds, and which may go up or go down in value. These annuities are called variable annuities.

When you are ready, you can convert the annuity lump sum into a stream of income. There’s no tax due on the transaction when you do this, but a portion of your annuity payment may be taxable as income if your projected stream of payments from the annuity, given your life expectancy, is greater than the amount of after-tax money you put in over the years.

Taxation of annuities

You don’t get to deduct contributions to an annuity, unless you hold the contract in an IRA, 401(k) or other tax deferred retirement plan. Annuities you hold in a tax-deferred retirement plan are called “qualified annuities,” while annuities you hold outside these accounts are called “non-qualified annuities.” However, with qualified annuities, you usually have to pay income tax on everything you take out of the annuity. With non-qualified annuities, you only pay income tax on the gain.

As long as money remains in the annuity, once you pay it, tax on the growth is deferred. You pay no income tax on dividends or interest whatsoever. And you can swap subaccounts within a variable annuity without incurring any capital gains taxes.

In fact, you can even sell one annuity and buy another annuity, under Section 1035 of the Internal Revenue Code, with no income or capital gains tax assessed on the transaction. Had you used a mutual fund, outside a retirement account, you’d have to pay capital gains taxes on every profitable trade.

The income tax you pay on annuity income, whether qualified or nonqualified annuities, is actually a disadvantage to the annuity contract: If you had skipped the annuity, and instead bought a mutual fund, outside a retirement account, you would pay the much lower long term capital gains rate – currently a maximum of 15 percent as of May 2012, though that will go up to a maximum of 20 percent as of January 1, 2013, unless Congress intervenes.


Because annuities are insurance products, rather than pure investment products, annuities may come with guarantees. For example, if you pay into a variable annuity that loses money, and you die, the insurance company will make up the difference, paying your heirs the amount you paid in, rather than the amount in your account after your subaccounts lost money.

Insurance companies can also provide additional guarantees, such as a guaranteed minimum income benefit, or guaranteed minimum withdrawal benefit. Other common features may include an annual inflation adjustment to income payments.

Fixed annuities (and their close cousins, fixed index annuities, or “equity-indexed annuities) also help shield owners from stock and bond market risk.


None of those guarantees are free, though. And the promises and protections you get with an annuity contract come at a cost. You will generally find that expenses are much higher than expense ratios on comparable mutual funds, and often approach 3-4 percent per year. In the long run, that can take a big chunk out of your expected returns – especially in a low interest rate environment, like we have now.

Annuities are also not well suited to be short or even medium-term investments. First, if you pull cash out of your annuity contract, or surrender a contract prior to turning age 59½, you will have to pay a 10 percent tax penalty on withdrawal.

This isn’t as bad as some people who don’t like annuities make it out: You have to pay the same penalty on IRAs and 401(k)s, and no one says those are terrible deals. And you have an out: If you commit to substantially equal periodic payments over the rest of your life – or the rest of your life plus one other person (usually a spouse), you can avoid the penalty under Section 72(t) of the Internal Revenue Code.

Second, almost all annuities come with a surrender charge period. If you have to sell an annuity or exchange it within a certain time frame (anywhere from 5 to 13 years, depending on the specific contract), you will usually have to pay a penalty to the insurance company. Each contract has a different surrender period. Since the insurance company, not you, pays the commission to the broker on annuity sales (it’s the other way around for loaded mutual funds, stocks and bonds), they impose the surrender charge to ensure they hang on to your assets long enough to recoup any commissions they pay and any other expenses associated with selling you the annuity.

Annuities are also generally irrevocable once you annuitize them: You can’t go back and un-annuitize an annuity once you make the election. It’s like trying to get a genie back into the bottle. However, you may get a guarantee from an annuity company to pay you at least the unused balance of your annuity.

Selling Considerations

One major issue with annuities is a function of how they are usually sold: Most annuities are sold by insurance salespeople: You need to have an insurance license to sell annuities. In many cases, the insurance salesperson recommending the product does not have a securities license. They cannot recommend a mutual fund or stocks or a zero coupon bond or Treasury bond if they wanted to – even if you would be better off in these products rather than an annuity. The salesperson will recommend what will get him paid, not what benefits you.

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