Should You Buy An Annuity? Questions to Ask First

Annuities come in many types. Here's what you should ask before you buy

Couple trying to decide if they should buy an annuity.
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Annuities are complex insurance products. They often pay high commissions to the people who sell them, providing them a strong incentive to convince you it is the right investment for you.

Before you buy an annuity you need to know why you are buying it, and what you expect it to do for you. Work through the five questions below to make sure the annuity you are buying is right for you.

1. What Type of Annuity Are You Buying?

There are many types of annuities. The most common types are immediate annuities, deferred annuities, and variable annuities. There are also fixed annuities and equity indexed annuities. Each works differently.

With an immediate annuity, you trade in a lump sum of money for a guaranteed stream of income. Immediate annuities can provide a fixed or variable stream of income, depending on the type of immediate annuity you buy. People who buy immediate annuities are looking for guaranteed income and want the assurance of knowing the income will last throughout their life expectancy. They understand they will no longer have access to their principal.

With a deferred annuity, you deposit your money with an insurance company and let it grow tax-deferred until a particular age or date that is stated in your contract. Deferred annuities can be either fixed or variable. A fixed deferred annuity provides a fixed rate of return which is guaranteed by the insurance company. A deferred variable annuity allows you to invest your funds in a portfolio of stock and bond sub-accounts.

People who buy variable annuities are looking for tax deferral and often a way to "insure" their future retirement income. The benefits that can be layered into a variable annuity are complex, and unfortunately, many people who buy them do not understand what they are buying. All too often the tax deferral in a variable annuity is not as beneficial as it may appear to be, and if you are not careful you can get talked into variable annuities with fees that are outrageously high.

Then there are equity index annuities, which are like a fixed annuity with a guaranteed rate, but you also have the potential to earn additional interest depending on what the stock market does. People who buy equity index annuities are looking for a safe investment that allows them to defer income taxes on the interest they earn.

2. Why Are You Buying an Annuity?

Before you buy an annuity ask yourself, “Why am I buying this?” Is it because it is the first solution that someone has presented to you? If so, step back and do additional research.

If you are buying an annuity because you have looked at many investment options, and chosen an annuity as part of your overall investment plan to complement other investments, then you are on the right track.

There is one thing an annuity does extraordinarily well: it provides a great longevity hedge. This means it preserves a minimum level of income that you cannot outlive. Allocating a portion of your money to an option that will provide income for life can make sense. Unfortunately, many people make investments, such as the purchase of an annuity, without first taking the time to create a long-term investment plan.

An investment plan helps you see what your money will do for you. Like a job description, once you know what the money needs to do, it is much easier to pick the option best suited to accomplish that job.

Don't let someone tell you an annuity can accomplish all your goals. It cannot. Every investment choice has trade-offs. 

3. What Are the Fees in the Annuity?

Each type of annuity has a different way of charging fees.

With a variable annuity, all fees are disclosed in the prospectus. Although they are disclosed, it can be difficult to figure out all the costs and how they apply. Many variable annuities have annual fees that are in excess of 3% a year. With high annual fees, your investments have to recover the fees before you actually make any money. That may be okay because an annuity is an insurance. You shouldn't buy it with the expectation of a great return. You buy it with the expectation that it will provide a minimum level of guaranteed income for your future.

With fixed and immediate annuities, the insurance company gives you a quote that is net of all fees. This works more like a CD or savings account. You get the interest rate offered which means the insurance company has factored in their costs before they determine the benefit they can provide to you.

4. How Will the Annuity Be Taxed?

Taxes should be considered as part of your decision-making process. Many times tax-deferral is used as a selling point for variable annuities, but unless you are in a very high tax bracket, and have a long time-frame before you need income, it may not actually be of much benefit to you.

Here's a quick overview of how different types of annuities are taxed.

When you purchase a deferred annuity, whether fixed or variable, the amount you invest is your cost basis. From that point on, any investment gains (or losses) are tax deferred. That means you will not receive a 1099 form, reporting the amount of interest, dividends or investment gains that are earned each year. These gains are all deferred. Tax deferred, however, is not the same as tax-free.

At such time as you take a withdrawal from a deferred annuity, you will receive a 1099 form that reports the distribution. Gain is considered to be withdrawn first, and all withdrawals are taxed at your ordinary income tax rate. Any withdrawals prior to age 59 ½ are also subject to a 10% penalty tax.

With an immediate annuity, a portion of each payment you receive is considered a return of principal (a return of your own money) and a portion is interest. You will pay tax on the portion that is interest but not on the portion that is considered a return of principal. The insurance company will provide you a tax statement that designates which portion is taxable.

Before you buy the annuity the insurance company can also tell you what your exclusion ratio would be. The exclusion ratio is the amount of each monthly payment that can be excluded from taxes.

If you convert a deferred annuity into an immediate annuity, the taxes will function like an immediate annuity, with a portion of each payment considered a return of principal, and a portion as interest.

5. What Happens to the Annuity Upon Your Death?

Upon your death, your remaining annuity benefits (if any) will go to the person you name as your beneficiary, but again, how this works can vary depending on the type of the annuity.

When you choose an immediate annuity you have to choose the term of the annuity. The term designates whether payments will be for your life only, for a joint life span, and whether any remaining funds will be passed along to heirs or not.

Most fixed annuity death benefits are simple; whatever the account is worth is what gets paid out upon death.

Variable annuity death benefits can be simple, or you can upgrade your policy with riders that offer enhanced death benefit options. These enhanced options can be a good choice for someone who does not qualify for life insurance but wants to find a way to boost what they pass along to a spouse or heirs.

Upon your death, the person inheriting the annuity must pay income tax on any gain, which will be taxed at their ordinary income tax rate. If they cash in an annuity with a large gain, it may push them into a higher tax bracket. If a spouse continues the policy, then the annuity is not considered to be cashed in, so no taxes would apply in that situation. Contrast this with what happens when someone inherits a portfolio of stocks or mutual funds. With stocks or funds that are not owned in a retirement account, heirs get a step-up in cost basis.

This preferential tax treatment does not apply to annuities.

Overall, an annuity bought for the right reasons, as part of a plan, is a great choice. But an annuity bought under pressure, when you don't really understand how it works, can end up being an albatross to your retirement plan.