Much has been written about Variable Annuities, but what is the real story about Variable Annuities
Variable annuities are a type of tax-deferred investment that may be just right for you if you have maxed out your total annual contributions to your IRA, your 401K or some other kind of tax-deferred investment vehicle. Before you get too carried away about variable annuities however it is important to be aware that not all annuities are exactly the same. In other words, they are not created equally. Many individuals think of annuities in very basic and simple terms. They think of them as a steady income stream or something that is analogous to winning money in a lottery.
Before you buy a variable annuity you need to become well acquainted with what the benefits and the downfalls of such are. A good understanding of the positives and negatives connected to variable annuities can go a long way in helping you to decide if this financial product is a good fit for you or if you should pass on it.
Defining an Annuity
An annuity is broken down into two broad categories. There are immediate annuities and tax-deferred annuities. When it comes to an immediate annuity, you make a lump sum deposit to the annuity account and the insurance company you deal with then guarantees that immediate monthly payments will be made to you until the day you die. The amount of money you receive on a monthly basis is connected to your life expectancy. This is very similar to the kind of payout you would receive if you won a big state lottery.
On the other hand, a tax-deferred annuity is such that you choose to invest your money and then you allow it to build tax-deferred until the point at which you decide to withdraw the money from the account. This type of annuity can have a fixed rate or it can have a variable rate that comes with sub-accounts attached to it.
Tax-deferred annuities are becoming more and more popular all of the time. These types of annuities use sub-accounts to place money amongst other types of investments, such as mutual funds. It is this type of variable annuity that we will now turn our attention to.
In the financial world variable annuities are often referred to as “mutual funds with an insurance wrapper.” While that may sound like a strange description of a variable annuity it is an accurate one. Variable annuities are an all-in-one package that is sold by an insurance provider. This type of annuity combines the benefits that go along with owning mutual funds with the characteristics of an annuity that is fixed (in other words, it has a fixed interest rate). The way it works is that investors pay a premium to the insurance provider. By so doing accumulation lots can then be purchased under the name of the investor.
The Advantages
Variable annuities sometimes get a bad rap. This is due to such things as inadequate disclosure and misleading sales techniques. Despite this there are some annuity products that are very good and well worth it to the individual looking for an investment vehicle. Look for ones that come with low expenses, are commission-free and have no surrender charges.
There are plenty of benefits that go along with owning an annuity. For example, one of the most appealing aspects is tax deferral of investment gains. Both your contributions, as well as your earnings are able to grow on a tax-deferred basis until the point at which you decide to start taking out your money. In this way they are similar to an IRA. Another advantage is ease of changing investments. Due to the fact that variable annuities come with sub-accounts that offer a selection of mutual funds to pick from, it is very easy and simple to change the investment direction you are heading in at little cost to you (or in some cases at no cost at all!).
Variable annuities offer income for the remainder of your life which can provide comfort and peace of mind to every investor. First you need to choose monthly payments from the annuity contract (known as annuitizing). From there the insurance company, as previously mentioned, will guarantee you that you will receive income payments from the annuity for the rest of your life. Your spouse can be included in this too if you so wish. Asset protection is possible in some states if you purchase a variable annuity. If you need a shelter with which to place your assets and not have your creditors go after them then this is one investment worth looking into further. Variable annuities can also be excellent savings tools for doctors and anyone who is employed in a financially hazardous field of work.
The Disadvantages
Unfortunately, all that glitters is not gold. In other words, there are some disadvantages to annuities that you need to become aware of. The concept of having income for the rest of your life sounds wonderful but there is one pitfall to it that many insurance companies fail to mention to their customers. That pitfall is that once you annuitize the contract it is frozen and the decision you have made is final. In other words, it is written in stone and cannot be modified. For example, your life expectancy plays an integral role in deciding whether annuitizing is beneficial or not. Under certain circumstances the insurance provider may end up keeping some of the remaining funds left in the annuity upon your death. This is not something that many investors feel very pleased about contemplating.
Another disadvantage is that once the money goes into an annuity you have no access to it until you turn 59.5 years of age. If you do dip into it early then you will have to pay a 10 percent penalty to the government. Once you do begin to withdraw money from the annuity account the amount of your payments that is viewed as being investment gains is then taxed at the normal income tax rate you pay as opposed to the long-term capital gains rate. For some people the income tax rate could be considerably higher than the capital gains rate. This is not something to smile about.
The Worst
The disadvantages above are only the tip of the iceberg as it gets worse. While annuities have some very good aspects they have some disturbing ones as well. For instance there are surrender charges to think about. Most insurance companies charge what is known as a surrender fee to annuitants. It is generally based on a diminishing seven-to-eight year scale. The fee starts at around eight percent in the first year that the annuity contract is started and becomes less over time. By year eight it is usually down to zero percent.
There is such a thing as front-end loaded annuities. Annuities in general are products that are commission based. Before purchasing an annuity ask how much of a commission the salesperson will receive for the annuity purchase made to you. If the individual stands to make a five percent commission on the annuity sale then it is extremely likely that your money will be under a surrender penalty for a term of five years or more. The sub-accounts you have that are composed of mutual funds will also come with fees. The types of fees you need to look for include front-load fees and 12b-1 fees, just to name a few.
Where you can really lose money on annuities is other fees such as annuity fees, administrative fees, mortality charges and expense charges. Many of these costs are buried within the contract of the annuity and are not obvious to the investor unless they read the fine print. All of these charges can reduce your annual profits. Most annuities charge in the area of 1.4 percent for these items but some can be as high as 2.5 to 3 percent.
