Figuring out what works for you, and what doesn’t.
When it comes to annuities and life insurance, it’s important to weigh your options. We discuss the basics—and a potential need for alternatives—with Matthew Schultz, co-Founder and advisor at 83rd Street Wealth Management in Palatine, Ill.
Light: What are the benefits and drawbacks of annuities?
Schultz: There are two basic types of annuities—fixed annuities and variable annuities. Fixed annuities pay interest and do not fluctuate in value. There is usually a guaranteed minimum interest rate. You are required to hold them for a certain term. If you close the account early, there are substantial penalties.
These accounts offer tax benefits and drawbacks. While the account is open, the interest is tax-deferred; however, when the interest is withdrawn it is taxed as income, not capital gain. In my opinion, the higher tax rate offsets the benefit of deferred tax. A zero-coupon bond offers a similar tax deferral but is taxed at capital gain rates. These types of bonds do fluctuate in value.
Light: What about variable annuities?
Schultz: Variable annuities are all different. All withdrawals are taxed as ordinary income, which is your highest possible tax rate. This is true even if the investments were held long-term or were dividends, which are usually taxed at a lower rate. This higher tax rate is also paid if an annuity is inherited. Annuities do not receive a step up in cost basis when the owner dies either. Stocks, bonds and exchange-traded funds do.
Light: Can you explain about the fees and penalties on annuities?
Schultz: Annuities come along with lots of fees, both disclosed and hidden. The investments inside variable annuities are usually mutual funds, but often are what is known as an annuity share. This allows the insurance company to attach another hidden fee. Vanguard estimates that the average mutual funds’ fees and costs are already 3.02%. Annuity shares charge those fees and tack on another without providing any benefit for the additional fee.
Riders are another fee you pay in an annuity in the form of insurance on the investments within the account. They can guarantee things like a minimum payout at death or income for a period. These riders each have their own cost and are not cheap. Unfortunately, people often don’t realize that a “benefit amount” on an annuity is often only valid if you take income over a period of 10 or 20 years, and in many cases, life. That means that you can’t cash your investment in as a lump sum without losing these benefits. If you close an annuity early, the penalties are often as high as 10%. The commission on the sale of an annuity is often 8%. This is amongst the highest in the industry.
Not surprisingly, high-commission investments attract a certain type of people to sell them. Getting honest information about annuities can be tough. At the end of the day, you have to evaluate each investment against your personal situation but be aware that with disclosed and hidden fees can often be as high as 10% per year.
Light: What are some alternatives you would suggest?
Schultz: In my opinion, insurance policies like whole life, universal life, variable life and variable universal life are not always a good fit for the investor. They are generally good for the salesperson. They, like annuities, often offer ridiculous fees, hard-to-understand benefits and some slick salespeople. If you need insurance, term policies can offer insurance at clear rates without many tricks.
If you want your investments to pay for your insurance, often I recommend opening an account and investing in indexes to pay your premiums from that account. You could save yourself substantially in fees. Like any advice, you should always talk to your financial advisor who can assess your entire financial picture. Not all solutions fit every person.
