Be wary of "the most oversold investment in America." What your insurance salesperson says is right for you may be just the opposite.
Hugh F. Doherty, DDS, CFP
Annuities are tax-deferred investments, wrapped in a thin veneer of insurance, that guarantees a future income stream. "Fixed annuities" pay market interest rates that are reset periodically. The more popular "variable annuities" let you allocate your deposits among various mutual fund-like accounts with fluctuating returns. Both are bad investments for most investors, because the tax deferral comes at a steep price - namely, high fees, a lack of liquidity, and capital gains that are taxed at higher ordinary-income-tax rates when withdrawn. They are also a terrible way to give or bequeath money to heirs.
The most oversold investment in America
The fact that variable annuities are confusing is one of my main complaints. I feel that it`s no accident that insurance companies have made their products difficult to understand. Unfortunately, most variable annuities are sold as a product, not as a solution to a problem. When you can earn a five to seven percent commission on a variable annuity and three percent on a mutual fund, the incentive is to recommend the variable annuity, especially when it`s a borderline situation that can go either way.
I am biased against insurance companies, and that bias extends to annuity products. It`s my philosophy that my doctors do not need a complex product. If a product is not simple, straightforward, and to the benefit of a client, then why bother?
Full disclosure is nonexistent
I have a problem with insurance companies in terms of what I see as a lack of full disclosure. Too often, variable annuities are sold without the doctor understanding what will happen when it`s time to take the money out. I am very critical of the way annuities are sold. During the sale, almost all of the focus is on the tax deferral, and very little attention is paid to the payout phase or, for that matter, to the client`s needs. In my opinion, at least 90 percent of doctors currently buying variable annuities should not be buying them. I avoid involving my clients in insurance products unless they have a clear and urgent need for them (i.e., term insurance). Most insurance products are one-sided, written to the company`s benefit, not the purchaser`s.
When might such a need exist?
Annuities should never be sold as a generic product that`s right for everyone. Let me describe some possible rare candidates and their situations.
In the first scenario, the doctor has maxed out his or her retirement-plan contributions, needs a guaranteed income at retirement, is in a low tax bracket, and does not have an estate-tax problem. The second situation would be one in which when the doctor/client has maxed out his or her qualified plan contributions, is willing to give up the capital gains tax break in return for the safety-of-principal guarantee, and has the discipline to keep his/her hands off the money which variable annuity penalties can create. The third candidate would be a doctor whose salary is too high to take advantage of a Roth IRA. He or she is maxed out on his/her 401(k) or other retirement plans, and has a sum of money to invest for retirement. The fourth situation would be someone in mid-life who plans to use the variable annuity for retirement income and has no need to pass any of the money to heirs. An example would be a 50-year-old doctor with no heirs and $250,000 that he currently doesn`t need. Because his earnings are relatively high and he has no financially dependents, he might consider putting his money into a variable annuity that will produce an income at retirement. The final type of client would be a relatively uneducated, unsophisticated person who is not prepared to handle a large sum of money, afraid to make a bad decision and willing to accept the risk that the insurance company will make better decisions than he or she can. This description does not fit most dentists in America.
Annuity versus a mutual fund
Your insurance person will argue that, if a variable annuity is kept in force long enough, the investor will come out ahead compared with a currently taxable investment like a mutual fund. He will tell you you`ll be ahead of the game, even considering the higher costs of a variable annuity and the favorable capital-gains treatment of mutual funds. Wrong! An accounting professor from a large Western university did a calculation showing that a person in a 36 percent tax bracket might need to hold an annuity 40 years to break even. If an investor needs the money in five years, he should be in a bond mutual fund or, better yet, buy the corporate bond (AAA), never "variable annuities."
If you ever want to send your insurance salesperson into shock, ask what kind of commission he or she will make on the sale. The average large-commissioned variable annuity has a hefty total annual operating expense plus insurance charges of about 2.2 percent, compared with about 1.4 percent for the average loaded stock fund. Annual contract fees average $25. The annuity`s additional cost comes from the death-benefit insurance (called the "mortality and expense" or "M&E" charge), plus the investment fees charged by the funds within the annuity.
Most variable annuities charge a declining surrender charge for assets taken out of the contract in the first seven years in excess of the "allowable withdrawal" (generally 10 percent a year). And, of course, any assets withdrawn from the annuity will face Uncle Sam`s bite: income taxes and a 10-percent penalty on early withdrawals if the owner is under age 591/2. Will the person need the money in the next five or 10 years? Will he or she need the money before age 591/2? If the answer to either question is "Yes," a variable annuity is not the right investment.
A tax trap
Variable annuity earnings are taxed at ordinary income-tax rates. Under current rates, this could be as high as 39.6 percent, compared with a capital gains rate of 20 percent for qualified assets held 12 months or longer. Eventually, an annuity could provide a higher after-tax return than a currently taxable mutual fund account, but, as noted earlier, it could take many years, depending on the annuity performance and costs. More often than not, analysis shows that the investor is better off in a mutual fund. Another downside is the lack of favorable tax treatment for variable annuities at death. The variable annuity`s beneficiary must pay income tax on the earnings, in contrast to mutual funds which receive a stepped-up basis at death and pass to the heirs tax-free.
How to get out of an annuity
I often hear from people who bought - or rather, were sold - tax-deferred annuities and regret it, and want to know what, if anything, they can do about it. They ask, "How do I get out of this mess?" The best solution is to not buy one.
But, if you have bought annuities, here are some suggestions:
1. Convert to a no-load. If you own a high-cost annuity, at the very least, wait until the surrender-charge period is over. Then, exchange it for one of the growing number of no-load, low-expense contracts via a tax-free, Section 1035 rollover. Don`t be fooled by a new crop of variable annuities that have no surrender charges. How can you tell them from the old kind? Agents sell them. Their loads are just buried in higher annual fees.
2. Take a tax loss. A little-known fact about deferred annuities is that, if you cash out at a loss, the loss is deductible against ordinary income. If you invested in your variable annuity`s emerging markets fund, for example, there is a good chance your investment is underwater somewhere in Mexico. If you cash out now, you can deduct the difference between your cost basis (all the premiums you paid minus anything you got back that was tax-free, such as dividends) and your account value after any surrender charges.
3. Just pay the taxes. Deferred annuities are meant to generate retirement income. The government allows your principal to grow tax-deferred and, in exchange, you are expected to spend down the annuity in retirement, paying taxes on your earnings as you withdraw the money. But what if, once retired, you find you don`t need the income? There is no escaping the tax on your gains. Cash in the annuity or transfer it to anyone other than your spouse and you trigger tax recognition of the full appreciation as income. Die with it in your estate, and your heirs will owe the income tax plus estate taxes if your estate is big enough. Nor does the law allow you to trade an annuity for a life insurance policy in a tax-free exchange. A solution is to maneuver into a lower tax bracket for one year ? say, by putting off a pension or IRA distribution ? and then cash in your annuity.
Another tactic is to start taking distributions from your annuity, pay the taxes over time, and funnel the balance to your heirs (or to an irrevocable trust for their benefit) to push it out of your taxable estate. The most tax-efficient way to do this is to OannuitizeO your annuity. This sets off a stream of monthly payments calculated to last the rest of your life. Each payment is part earnings, part return of principal, so you are still able to defer some taxes. The downside to annuitizing is that, if you die early, you forfeit what?s left in your account. To protect their inheritance, the heirs could invest the money in such items as growth stocks instead. Here they would owe capital-gains taxes.
4. Payout time. If you made the mistake and purchased an annuity, there?s another important factor. You must look hard at the payout phase.
I never recommend annuitization because it locks in your monthly payments and, if you die early, there?s nothing for your heirs. It ties up your money and commits you to a fixed payment without knowing what the future holds. You want to stay in charge of your destiny. You don?t want to give up control of your money to the insurance company just so it can send you a check every month, even if there are some tax advantages to doing it that way. Also, the variable annuity provides nothing for your heirs unless a joint annuitant is named, and then the monthly payout will be smaller. I believe that you should run the numbers and compare the annuitization options offered by the company along with the option of taking a lump-sum payout or a periodic withdrawal. It?s not simple to do, but it?s very important to do.
There is no graceful way to divorce from an annuity. The best solution: The next time the insurance salesperson comes calling to sell you an annuity, lie very still and don?t answer the door.