Fixed annuities are typically considered long-term investments. While there are many advantages to fixed annuities, there are also disadvantages. As with anything, it is a matter of weighing the good attributes with the bad ones.
Pulling out money from any annuity prior to the age of 59.5 will result in a 10% tax penalty on top of the ordinary tax rate. This means a potential tax rate of 45%. Needless to say, the IRS penalty can eat into your growth substantially. This is why annuities are considered a retirement investment vehicle and aren't well suited for younger investors. There are however two streaks of silver lining:.
Firstly, the IRS will never assess taxes on your principal. In annuity investment, income is all that's ever taxed, and in this case, only that which you earn beyond your initial investment would be subject to the 10% IRS fee. At worst you make less money; you never lose money.
Secondly, this penalty can be completely avoided. For an immediate fixed annuity, don't invest unless you're over 59.5 years of age. For a deferred fixed annuity, make sure you'll be over 59.5 when it comes time to withdraw income. You always have the option to rollover one annuity into another indefinitely, so you needn't worry about timing the contracts maturity date to your 60th's birthday. Other ways the IRS penalty can be avoided:
Don't mistake tax-deferred growth with tax-free growth. While the annuity is active your money will grow tax-free, but eventually, when you or a beneficiary starts to withdraw income, it will be subject to the ordinary tax rate of the individual making the withdrawal.
Why is this a negative? Because, in relation to other investment options like CDs or mutual funds, you could have been charged the more favorable capital gains rate. In a worst case scenario your tax bracket could be as high as 33%, State + Federal. That's more than double the 15% capital gains rate. There are however two mitigating factors:
All things being equal, the advantages of investing in a fixed annuity tend to outweigh those of investing in a CD or mutual fund. Over a long time-frame, tax-deferral + standard income tax beats out annual tax + capital gains tax. Consider the savings in the following example:
John and Joe both invest $500,000 for retirement. John invests in a fixed annuity for 20 years, Joe invests in CDs or a taxable money market for the same time-frame. Let's assume both earn an annual return of 9% and fall into the same 33% tax bracket.
After 20 years, John has accrued $2,802,205 while Joe only $1,612,669. But Joe's already paid his taxes. John has yet to pay his share. 30% of $2.8M minus the $500k premium (which isn't taxed) yields John $2,041,478. Not bad, John's fixed annuity beat Joe's CD by over $400,000! Even if Joe invested in a completely tax-free money market at 5% (a typical rate), he still wouldn't beat the fixed annuity. In fact, he'd make out worst of all.
A withdrawal charge is imposed by the insurance company whenever you try to take out cash from an annuity before it's maturity date. Some annuity contracts don't have withdrawal charges at all, but most feature a penalty that phases out over time. For example, a typically fixed annuity might stipulate a 4% withdrawal penalty with a 5 year phase-out schedule. For this annuity, a withdrawal in the first year results in an 5% penalty. In the second year it drops to 4%, then 3%, then 2%, then 1%, and finally, after 5 years, you can withdrawal as much as you like penalty-free.
Withdrawal fees are a downside of virtually all annuity contracts, but they far from render these products useless.
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