A lot of ink has been spilled on the pros and cons of annuities. Advisers tend to have strong opinions about annuities. Insurance professionals often recommend them. But then, annuities pay relatively high commissions. Stockbrokers and Wall Street advisers often don’t like them. But they are trying to sell a competing product, so they have reasons of their own to shoot them down.
Are they good or bad? The answer is somewhere in between: They are excellent for some purposes and poor for others.
What is an annuity?
Annuities explained: An annuity is a contract with an insurance company in which they agree to provide you with a defined income, in exchange for you contributing money, or premium.
The income can be defined as a specific dollar amount, or it can be defined as a minimum benefit, with the potential for an increasing benefit over time.
If you do choose to buy an annuity contract you can have the stream of income start immediately (an immediate annuity), or delay it until retirement, or some other future date you select (deferred annuity).
Generally, once that stream of income starts, you’re committed to receiving that income over your lifetime, the joint lifetimes of yourself and a loved one, or for the length of time specified in the annuity contract.
Annuities can be fixed – that is, generate a defined and guaranteed interest rate over time – or variable. A variable annuity performs according to the underlying investments in the subaccounts that you choose.
Taxation of annuities
Generally, contributions to annuities are not tax deductible, though if you own them in a 403(b) or 401(k) your contributions to these plans may be pre-tax. After that, they grow tax-deferred as long as the money remains in the annuity.
When you begin taking money out of the annuity, the growth is taxed as ordinary income – which can be in a relatively high rate for physicians who generally command high incomes. However, you do get credit for taxes you paid on money you contributed. So if you paid premiums with after tax money, only a portion of your income from the annuity is taxable – not the entire thing.
If you take money out prior to turning age 59 ½, you’ll pay a 10 percent penalty on top of any income tax due. You also have to begin taking money out (and paying taxes) by April 1 of the year after the year in which you turn age 70½ – that is, take required minimum distributions (RMDs), or pay severe penalties.
Once the money is in the annuity, then, the taxation is similar to that of a traditional IRA or 401(k):
- Tax-deferred growth
- 10 percent penalty on early withdrawals
- Earnings above your taxable basis are taxable on withdrawal at ordinary income rates
- Subject to RMDs.
Earnings on, say, mutual funds or other securities outside of retirement accounts are generally taxed at lower capital gains tax rates. And you can sell losing positions to offset gains to lower your total capital gains tax liability. You can’t do this with mutual funds. So from a tax point of view, a portfolio of mutual funds, stocks and bonds may be more efficient than an annuity.
As insurance products, Annuities also tend to have higher internal expenses compared to mutual funds. This is because you’re paying extra for the insurance guarantees that come with the annuity contract: If the market tanks, the annuity will provide some protection against market risk. You will still get the income promised in the annuity contract, regardless of market forces.
Benefits of annuities
The greatest benefit of the annuity contract is in the guarantees:
- You can choose an annuity that provides a guaranteed income that you can never outlive.
- You can stretch this guaranteed income over two lifetimes – your own and your spouse, child or even a grandchild.
- Guaranteed minimum income benefits
- Guaranteed minimum withdrawal benefits
- Reduced or eliminated stock market risk
- Inflation protection available (at a cost)
- You can roll one annuity into another tax-free via a 1035 exchange.
- Tax-deferred growth with no annual contribution or income limits
- No out-of-pocket commission. The insurance company pays the agent, not you. So every dollar you put in compounds for you. They don’t subtract commissions from your contribution.
- On death, annuities pass directly to designated beneficiaries, bypassing probate.
- Protection from creditors in some jurisdictions
Drawbacks of annuities
- Annuities frequently come with surrender charges for a number of years after you buy the annuity. That is, it may cost you money to sell the annuity if you don’t like it.
- Higher fees and expenses
- Fees for various insurance riders and guarantees can add up
Do they make sense? Despite the higher fees and surrender charges, it sometimes makes sense for physicians to have part of their long-term retirement portfolios in annuities. Some choose to put enough in annuities to guarantee enough income to cover their most basic expenses. Some choose to emphasize safety and guarantees using annuities or a combination of annuities and cash value life insurance. Others choose to take on more uncertainty by emphasizing stocks and mutual funds, accepting some more stock market risk.
Which is the better approach? There’s no single answer. It’s entirely up to the individual.
But beware of any advisor who goes to either extreme: Annuities are not wholly good nor wholly bad. They are useful risk manage tools, but tend to function poorly as long-term investments for people who have a high tolerance for risk.
Annuities for physicians serve an important role in many portfolios, but are not the perfect financial product for everyone.
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