Annuity Disadvantages
It is only fair to present both the advantages and disadvantages of annuities. Here are the major disadvantages to an annuity.
Pre-59 1/2 distribution penalty of 10 percent: Like your IRA, an annuity has a penalty if you need to get the money out before 59 1/2 (with few exceptions).
Surrender penalty: Most contracts have a fee if the contract is surrendered within the first five to 10 years. This is because the insurance company paid a commission to the person who sold the annuity.
The more the agent was paid, the longer and more punishing the surrender penalty. However, there are a few products, although not commonly offered, that don't pay commissions and thus don't have surrender penalties.
In fact, you are converting potential capital-gain taxation for ordinary income. This is the primary reason to look into current and projected future tax rates before buying.
Step-up in basis at death: Current estate tax laws allow for stock or mutual fund investments passed on to beneficiaries to be valued at the owner's date of death, which is called a step-up in basis. Annuities do not have this feature, and all gains are treated as ordinary income.
Mortality and expense charges: Annuities have, on average, an annual 1.3 percent charge against the assets plus a $27 annual administration charge for what is termed "mortality and expense charges." This is in addition to the underlying investment fund charges.
According to the article, "Are Variable Annuities Right for Your Client?" in the January 2003 issue of the Journal of Financial Planning, this creates a five- to 15-year break-even period for those highly taxed individuals, depending upon the amount of M&E charged and the individual's tax rate.
Mutual fund availability: Another meaningful point rarely included in an analysis of annuities vs. after-tax accounts is the assumption that each hypothetical case has the same investment options.
Variable annuities have a finite sub-account fund selection.
When you consider that Morningstar tracks more than 15,000 funds and the average annuity might offer between 30 and 50 sub-account funds at most, why isn't fund selection or competitiveness a consideration?
Is it unbiased to consider that the same returns available in the mutual fund universe also should be available in the annuity portfolio?
Annuities in IRAs: The single most disturbing trend we regularly see is the annuity sale in IRA accounts. Although annuities may be appropriate for individuals in a higher marginal income tax bracket, we do not believe it is appropriate for an IRA investment. Since an IRA is already a tax-deferred vehicle, we see no reason to pay the higher fees charged by the annuity.
After all this, the best advice is to go through a comprehensive appraisal of your situation by a certified financial planner (CFP).
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