Why You Might Not Want to Buy an Annuity

An annuity is a contract between an individual and an insurance company, designed to provide a steady income stream. This financial product accumulates funds on a tax-deferred basis for future income needs, especially during retirement. Annuities offer financial security by converting a lump sum or series of payments into regular disbursements.

Costs Associated with Annuities

Annuities come with various fees and charges that can reduce their value and the returns an individual receives. These costs compensate the insurance company for services and guarantees provided.

Administrative fees cover the costs of managing the annuity, including record-keeping, processing transactions, and customer service. These fees can be a flat annual charge, ranging from $30 to $50, or a percentage of the annuity’s total value, around 0.3% to less than 1% annually. Variable annuities, which involve underlying investment options, also include mortality and expense risk (M&E) charges. These charges compensate the insurer for insurance risks, such as guaranteed death benefits or lifetime income options, and range from 0.20% to 1.80% annually.

Additional benefits, known as riders, can be added to an annuity contract for enhanced features like guaranteed income or death benefits. These riders incur fees, charged as a percentage of the annuity’s value, between 0.25% and 1% annually. A significant cost is the surrender charge, a penalty imposed if funds are withdrawn before a specified period, ranging from 3 to 10 years. This charge starts high, 7% to 10% in the first year, and gradually decreases over the surrender period.

Commissions paid to agents for selling annuities also contribute to the overall cost, though these are built into the contract and not paid directly by the purchaser. Annuity commissions range from 1% to 10% of the total value, with 5% to 8% being a common range, influenced by the annuity’s type and complexity. These charges can significantly impact the net growth and income potential of an annuity over time.

Limitations on Access to Funds

Annuities are designed as long-term financial products, meaning funds invested are not immediately accessible. This lack of immediate liquidity is a consideration for individuals who need access to their capital for unforeseen circumstances. Annuity contracts impose specific surrender periods, which can last anywhere from three to ten years, during which early withdrawals incur surrender charges from the insurance company.

Beyond contractual surrender charges, withdrawals made before age 59½ trigger an additional 10% penalty from the Internal Revenue Service (IRS). This federal penalty applies to the taxable portion of the withdrawal, further diminishing the amount received. While some annuity contracts allow for penalty-free partial withdrawals, up to 10% of the account value annually, exceeding this limit or making full surrenders during the surrender period results in both company charges and IRS penalties. These restrictions mean annuities are unsuitable for individuals needing frequent or substantial access to invested capital in the short or medium term.

Investment and Income Considerations

Investment characteristics and income generation of annuities vary by type, but certain aspects limit their appeal. Fixed annuities provide a guaranteed minimum interest rate, offering stability but limited growth potential compared to market-exposed options. This limited growth means the purchasing power of fixed annuity payments can be eroded over time due to inflation.

Once an annuity contract is annuitized, the decision becomes irreversible. This irrevocability means the owner cannot change the payment structure or reclaim the original principal, limiting flexibility. If certain payout options are chosen, such as a life-only annuity, the remaining principal may be forfeited upon the annuitant’s death, resulting in a loss of unused funds for beneficiaries.

Some annuity products, particularly variable annuities, can be complex, featuring numerous investment subaccounts and optional riders. This complexity can make it challenging for the average person to understand the product’s mechanics, risks, and how various fees impact returns.

Tax Treatment of Annuity Withdrawals

Annuities offer tax-deferred growth, meaning earnings within the contract are not taxed until withdrawals begin. While this deferral allows money to compound more efficiently, the taxation of withdrawals is a consideration. When earnings are withdrawn, they are taxed as ordinary income, which can be at a higher rate than long-term capital gains, depending on an individual’s tax bracket.

For non-qualified annuities, funded with after-tax dollars, withdrawals are subject to the “Last-In, First-Out” (LIFO) rule. This rule dictates that earnings are withdrawn first and are therefore taxed before original principal contributions. Once all accumulated earnings have been withdrawn and taxed, subsequent withdrawals represent a return of the tax-free principal.

Beyond ordinary income tax on earnings, withdrawals made from an annuity before age 59½ are subject to an additional 10% federal income tax penalty. This penalty applies to the taxable portion of the withdrawal, further increasing the cost of early access to funds. This tax treatment differs from investment vehicles that offer capital gains rates for long-term holdings.