Fixed Annuity Hazards
Pitfalls of Purchasing Fixed AnnuitiesAnnuities are often criticized for having high surrender charges. As with any investment, fixed annuities have their pitfalls, but knowing what to look for in an annuity will help ovoid many problems.
- Don't purchase a fixed annuities with money you may need immediate access to. Your premium is safe, but early withdrawals are subject to fees.
- Investing Too Young: In most cases, surrendering out an annuity before the age of 59.5 will be subject to a 10% penalty from the IRS.
- Find out how low the interest rate can go. Many fixed annuities are structured with an interest rate that may change over time. When purchasing an annuity, make sure you know how long the rate is guaranteed for and how low the rate can go.
- Withdrawal Charges: Early withdrawals from a fixed annuity may incur a surrender charge. Make sure you ask what percentage you can take out in 'free withdrawals.
- Free Withdrawals Provisions: Annual penalty-free withdrawals might exclude principal.
Most Common Mistake: Investing for the Short-term
The number one thing you would not want to do is purchase an annuity with funds that you will need access to before it reaches the end of the surrender charge period. Typically with an annuity, the penalty for surrendering early will decrease over time. It may start out at around 10%, but in the last few years of the contract it would be down to 1%-2%. Annuities are designed to be retirement savings vehicles much like a 401(k) and should not be invested in short-term. Because they aren't as liquid as mutual funds or money market accounts, you should only invest retirement savings.
If you purchase an immediate fixed annuities you'll begin to receiving a guaranteed monthly income right away and the payment amount typically will not change over time. Keep in mind that to total amount you invest will not be available as a sump sum, so just make sure you are comfortable with the payment amount before be purchase. You'll want to get a rate quote for your immediate fixed annuity and calculate the monthly payouts.
Too Young for an Annuity:
Because investors are not taxed on the interest they receive each year with an annuity, the IRS imposes a 10% tax anytime funds from an annuity are accessed before the annuitant reaches 59.5. Using an annuity to fund a child's college education would not be suitable if the funds were needed before reaching the age requirement. Be sure to plan your annuity such that you're over 60 when it comes time to collect.
A fixed annuity should be thought of as a 401(k), which too imposes penalties for early withdrawal. Think of it not as a penalty but an incentive — the government wants to encourage you to save for retirement.
The Shorter-than-Expected Guarantee
A commonly overlooked aspect of many fixed annuities is the limited extent of their guaranteed rate. Read the contract carefully to determine how long the guaranteed rate actually lasts, because it can differ from the contract term.
For example, a fixed rate annuity might advertise itself as 6% fixed for 10 years, but if you ask the agent how long the guaranteed rate lasts, he might say, "the first 5 years". This is a common case, which means the rate could drop on year 6.
Although this limited guarantee can come as a surprise, it's not as bad as it sounds because most annuities feature a bail out provision. The bail out is a clause in the contract that allows you to cash out, penalty-free, if the guaranteed rate ever drops under 1% of the original. Meaning, should the rate drop from 6% to 4%, you can switch to another annuity free of charge.
Many annuities assess fees for early withdrawal beyond a specified yearly allowance. A typical withdrawal fee might start at 8% the first year and phase out to zero within 4 years. Such fees will adversely affect your returns, but on the up side, they're easy to avoid.
As long as you don't invest money needed to make ends meet, you won't be prone to early withdrawal. Statistics confirm that over 75% of annuity investors don't withdrawal early, avoiding the insurance company penalty altogether.
But let's supposed worse comes to worse and you have a rainy day. Even then you have a buffer in the form of a yearly withdraw allowance. This allowance ranges from 5-12%, letting you withdrawal $10,000 per year on a $100,000 investment penalty-free.
Comparing Apples to Apples: nearly all alternative long-term investments have penalties for early withdrawal — CDs, mutual funds, 401(k)s, IRAs, and even treasuries. That's because longer-maturing equities (loans and bonds) yield higher rates. It's also in the bank's or insurer's interest to hold your money as long as possible.
For example, a 1-year CD typically charges a 3-month interest penalty for early withdrawals. A 2-year CD charges a 6-month interest penalty. Even with T-Bills, interest is guaranteed only if they're held until the maturity date.
Interest-Only Penalty-Free Withdrawals:
Fixed annuity contracts typically allow an annual 10% free withdrawal from the policy. These funds are available outside of the surrender charge schedule, however the IRS 59.5 rules still apply. This feature can be used in the case of an emergency where cash is needed immediately, or when the annuitant wishes to take it as income.
Example: John invests $100,000 in a fixed annuity at 6% for 10 years. His contract stipulates a 10% interest-only annual allowance. After the first year, John could only withdrawal $6,000 penalty-free, because that's how much income the annuity with generate in one year at 6%. If the annual allowance hadn't been interest-only, he could have withdrawn $10,000 penalty-free.
In practice, interest-only allowances aren't terribly confining. Notice that at the end of year two, John would have generated enough income to withdraw 10% penalty-free. As long as John doesn't plan to withdrawal 10% every year, he won't incur any penalties.
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