Annuities are not inherently bad or good, but they are complex and you should understand the various components of them before committing to one. The best annuities are those that fit your preferences closest.
In this article, we’re looking at some of the potential pitfalls of annuities and how you can avoid some of the risks involved in buying them. Remember, most investments carry pros and cons and conducting research into how you can avoid some of those cons is the key to maximizing any investment. However, there is no such thing as a guaranteed investment and you should approach your retirement investment strategy with this in mind.
One of the drawbacks to annuities is that they can be complex. To start, just learning the many varieties they come in can be daunting. Should you buy a single premium immediate annuity, a deferred payment annuity with a variable rate.
There’s also an extensive vocabulary to learn surrounding annuities. Terms such as mortality and expense fees, joint life payouts, and sub accounts can leave you scratching your head wondering what you were thinking when you decided buying an annuity was a good decision. Furthermore, not understanding these terms can cause you to make poor decisions regarding your annuity.
When you buy annuities, you pool your risk with others buying annuities. The insurance company you buy the annuity from manages that risk and you’re paying a fee for them to manage that risk. It’s like insurance for your retirement income. As with say, homeowners’ insurance, if your house doesn’t get destroyed by a flood, that money is essentially just handed to the insurance company.
When you leave investments such as stocks, bonds, and mutual funds to heirs, your assets receive a step-up basis. This means that if you invest $5,000 and it appreciates to $10,000 after you die, the IRS won’t tax your heirs if they sell it immediately at $10,000. If they sell it two years later for $15,000, they will still only pay $5,000 and the money will be taxed at the long-term capital gains rate.
With annuities, if you leave your heirs an annuity you bought for $10,000 that’s now worth $20,000, they will have to owe $10,000 of ordinary income. Annuities do not have a step-up basis to reduce taxes for your heirs after your death.
Annuities can be anywhere from 3-20 years and they have penalties attached if you decide to opt out of them. Annuities can allow for withdrawals without a penalty but if the annuitatnt (the person who owns the annuity) withdrawals more than the allotted amount, they can incur penalties.
Flip Side: Short-Term Annuities
Short-term annuities can safeguard you from lengthy contracts that solidify you into an undesirable position. They are commonly referred to as immediate annuities and you start receiving payments immediately after you pay your lump-sum deposit. After you make your lump-sum payment, your deposit get invested into conservative assets.
Many individuals nearing retirement age choose immediate annuities because they don’t have an accumulation period. However, when you begin receiving payments from an immediate annuity, at least a portion of your payment becomes taxable. These annuities feature illiquid assets and you must keep your money in the annuity once you make the initial investment.
Lack of Investment Control
Some annuities require you to forfeit substantial investment control in control for your stream of income. Who doesn’t want control over your finances. Varying annuities provide different monthly payments. If you’re investing in an annuity, you need to make sure you buy one that affords the highest monthly payment. Or, at least purchase one that fits your income needs.
Your annuity might also not earn any interest because some offer little to no growth potential. In these cases, your retirement plan won’t grow fast enough and you will have less money than you need to retire.
Flip Side: Flexible Income Annuities
Flexible income annuities are variable contracts designed to build savings for retirement. These accounts credit higher interest rates that afford you some more control over the return on your investment. They also feature tax-deferred benefits that allow you to control some of your tax obligations since you aren’t taxed for them until you make withdrawals.
They May Not Keep Up With Inflation
Yes, annuities offer lifetime income.But not all annuities adjust the income for inflation. If you start your annuity payments too soon, you might not be able to keep up with the increase in the cost of living. This will put you at risk of having insufficient funds later in life, perhaps the worst time to have financial troubles.
Limited to No Liquidity
Annuities will offer a limited amount of liquidity per year, at best. Most of the opportunities for liquidity you face will carry penalties or fees and some annuities offer no liquidity whatsoever.
Many annuities carry hidden fees that you need to pay close attention to when choosing your annuity investment.
The Flip Side: Annuities That Offer More Liquidity
Some annuities feature benefits that increase your annuity’s liquidity. Annuities without fees and those that feature penalty-free withdrawals are some of the best annuities available. Some annuities even offer returns on premiums.
Examples of annuities offering more liquidity include those that don’t have surrender charges and annuities with more liquidity than standard annual penalty-free withdrawal provisions.
You Have to Wait for Your Income
You might have to wait to start receiving annuity payments. This is not ideal if you need immediate income protection.
Conclusion- Are Annuities Bad?
Annuities aren’t inherently bad but they do not fit your retirement portfolio. That’s why it’s important that you have a trusted annuity advisor with you when choosing one. Reputable annuity agencies will walk you through the process to ensure you’re choosing the annuity that best fits your retirement portfolio preferences.