Annuities

What Is An Annuity?

There are two basic types of annuities: deferred and immediate.  Most annuities sold in this country are deferred annuities.  An annuity is a tax-deferred vehicle for savings that can be converted to a stream of income payments at the option of the owner.  Few annuities are converted in this way, however.  Most annuity owners prefer to keep the cash available for withdrawal.

Many annuities are sold through seminars in which a financial advisor tells the audience that annuities are a method of protecting their assets, avoiding income tax on their social security income, and a wonderful investment that will not only beat other investment returns, but guarantee certain payments regardless of how the investment actually performs.  However, there are quite a few disadvantages to purchasing annuities that most advisors don’t emphasize.

Annuities Are Subject To Ordinary Income Tax and Possible Penalties When Money Is Withdrawn

Unlike life insurance, income from an annuity is fully taxable at ordinary income rates.  In addition, any money withdrawn before the owner attains age 59 ½ are subject to a 10% penalty tax.  This is a significant disadvantage over mutual funds, which are subject to preferential capital gains tax rates and may be withdrawn at any time and used for any purpose at will.  If a financial advisor counsels the conversion of mutual funds into an annuity without advising of these tax consequences, it may be malpractice or a breach of fiduciary duty or both.

Surrender Charges

Most annuities allow the owner to withdraw up to ten per cent of their money annually without penalty.  Any withdrawal beyond that amount is subject to a declining surrender charge of up to 15% (fifteen per cent) of the amount withdrawn.  After a number of years (usually 5 to 15), the surrender charge declines to 0.  Many annuities are sold as rollover annuities: i.e. the advisor presents a newer and “better” annuity and urges the client to surrender his or her previous annuity and roll it over into the new one.  One of the worst practices in the industry is that advisors in many cases will give this advice even though the prior annuity (the one being surrendered) is still itself subject to a surrender charge.  When confronted with this issue, the annuity companies’ response has been to add a “bonus” of a certain percentage (often ten per cent) to “make up for” the surrender charge.  This “bonus” is actually an illusion: it is paid for by additional fees that more than compensate the insurance company for the extra expense.  The net effect to the client is that they lose the surrender charges on the first annuity and wrongly believe they have lost nothing.  They also start the running of a NEW surrender period.

Summary of New NASD Rule regarding Variable Annuities