Annuities - An Investment Tool
Chapter 6
Disadvantages of the Annuity
This chapter will discuss the disadvantages of annuity investing. Again, as stated in the last chapter, we may not cover all the disadvantages the insurance producer thinks should be there. This course is designed to cover some main points/disadvantages.
As with any investment, due diligence should be practiced. Both the insurance producer and the prospective investor need to know the advantages as well as the disadvantages of any product. This means the insurance producer must acquire a complete understanding of the products. The disadvantages of annuity investing are few and may not even apply to the prospective investor.
No matter what type of annuity contract the policyholder chooses, it is subject to a ten percent IRS tax penalty for withdrawals of growth or income made prior to age 59½. No penalty is imposed on the principal contributions when they are taken out. There are four ways that can avoid the IRS penalty. They are:
If the annuitant dies, it does not matter how old they were, all IRS penalties are waived. Disabilities are defined in Section 72 of the Internal Revenue Code. The death or disability of the annuitant, not the contract owner or beneficiary, will prevent an IRS penalty. Annuitization will prevent any IRS penalty but the contract owner must elect annuitization within one year after investing in the annuity. Reaching 59½ is the last way to avoid penalties. The measuring of life here is the contract owner, not the annuitant.
Annuities may not be the wisest choice for a younger couple unless the annuity investment is part of their retirement plan, such as an IRA, Keogh, pension or profit-sharing plan or unless the contract owner is an individual or couple who will not need the money in an emergency. Fixed or variable rate annuities may be ideal for the older investors near or past the age of 59½.
An annuity investment means that the money will grow and compound tax deferred, not tax free. Any and all income tax liability can be postponed indefinitely. In the previous chapter we noted that if a spouse died and the other was listed as the beneficiary, it would not incur a tax event. If the remaining spouse then remarries, and names themselves as the annuitant and the new spouse as the beneficiary the money would be transferred to the new spouse upon the death if the annuitant. When both spouses die, the beneficiaries can postpone taxes for up to an additional five years. There are no ways to avoid taxes forever. At some point, income taxes will have to be paid.
The tax liability is the difference between the amount invested and the value of the annuity contract, multiplied by the beneficiary's tax bracket.
The eventuality of paying taxes may not be all bad. The owner of the annuity has the ability to decide when to withdraw. Hopefully, the owner of the annuity will be able to withdraw when they are in a lower tax bracket.
Surrender charges can be a big disadvantage depending on the annuity contract and insurance company. This penalty only applies if the policyholder takes out more than the allowed amount of money from the contract within a set number of years.
When a person invests in an annuity, they can take noncumulative annual withdrawals between ten and 15 percent a year, depending on the contract, without penalty after the first year. An insurer penalty occurs if the policyholder takes out an amount in excess of that free withdrawal privilege. The amount of the penalty varies depending on the insurer's penalty schedule. When looking at different annuity options, it may be wise to look at the insurer's (insurance company) penalty schedule. The penalty period can vary also between companies.
There are ways to avoid the insurance company penalty schedule. They are:
The guaranteed death benefit, mortality and expense fees, are a feature of all variable annuities; fixed rate annuity contracts do not possess this charge. This charge can range from 1.1 percent to 1.5 percent annually depending on the insurance company and the term of the annuity contract. This fee is levied against your account balance every year - annually. The fee the insurance company charges can never be increased. The fee may be hidden in that it does not show up on quarterly or annual statements. It is described in the prospectus. The prospectus defines the different types of subaccounts within the variable annuity, charts the previous performance of these investments, and lists any and all charges that will be deducted from the variable annuity portfolio.
The mortality fee is a small percentage figure based on the total value of the variable annuity contract. The greater the annuity account, the more the insurance company will end up collecting. There are three good things that can be said of the mortality charge:
It helps to pay for commission and overhead costs that normally would be paid in the form of an up-front or ongoing sales charge.
It gives the insurance company an incentive to hire the best possible money managers on each portfolio. The insurance company will make more money as the account grows.
The mortality charge insures the integrity of the guaranteed death benefit.
This type of guaranteed benefit cannot be found with any other type of investment.
Another charge that can be considered a disadvantage is the contract maintenance charge, though this is minor compared to the mortality fees. The annual contract maintenance charges can range from $25 to $50, depending on the variable annuity contract and insurance company.
The maintenance charge shows up on the insurance company's fourth quarter statement. It is deducted from the current value or the variable annuity at that time. The maintenance fee is a flat charge no matter what the dollar amount of the annuity is.
This fee can never increase during the life of the contract.
End of Chapter 6
United insurance Educators, Inc.