Annuities: Understanding All the Costs
An annuity is a type of investment that provides a stream of income. In the past, annuities were considered risky investments because they had high fees and penalties associated with them. However, today's annuities are much more transparent and some have lower cost than their predecessors. This article will discuss all the costs associated with annuities and whether they may make sense in an overall financial plan.
Annuity Income — The Income You Get From the Annuity
Annuity income is the money you get from an annuity contract. It's paid out to you over time, and it can be paid in one lump sum or in monthly payments.
The amount of annuity income you'll receive depends on several factors:
- The amount of your initial deposit.
- Whether your annuity is fixed or variable (explained below).
- Any bonuses or other benefits included with the contract.
- What type of payout schedule you pick.
Variable Annuities vs Fixed Annuities — What is the Difference?
Variable annuities are like mutual funds in that they offer the potential for higher returns, but they also come with more complexity and fees. A variable annuity is an insurance product that allows investors to invest in sub-accounts that have the potential for returns greater than those of fixed-rate investments such as CDs and money market accounts.
When you purchase a variable annuity, you are investing in a portfolio of investments through your insurance company. Each investment has its own set of risks and rewards, so it's important to choose the right one for your needs.
Fixed annuities are simpler and have fewer fees, and they guarantee your principal back at maturity. An immediate annuity is a type of investment that guarantees a set amount of income for the rest of your life.
Annuity Commission Amounts — How Much Do Agents Get For Selling You an Annuity?
One of the most important things to understand about annuities is that there are additional costs associated with them. The commission is a percentage of the total amount invested and can range from 0% to as high as 10%. The commission percentage can be found in the annuity disclosure document.
This is one of the reasons why it's so important for you to do some research before purchasing an annuity. A fee only Certified Financial Planner can help determine what the commission costs are and whether or not they make sense inside a financial plan and strategy. As we noted many times in various articles, commissions impact the overall return of any investment since these costs always impact the overall return.
Underwriting Fees for Annuities — What are They and How Much Do They Cost?
Underwriting fees are the amount of money you have to pay to get your annuity. They are usually a one-time fee that is paid when you buy your annuity. Underwriting fees can be charged by the insurance company as part of a commission, or they may be charged as an administrative fee.
Fund Management Fees with an Annuity — What Are They and What Do They Cost?
Fund management fees are charged by the insurance company to cover their investment and administrative costs. These fees are usually charged as a percentage of your total value, but some companies may charge a flat rate instead, so you may want to check with your provider for more information about how fund management will be calculated in your specific annuity. Annuities typically have several types of fees that can be added over time.
Annuity Penalty Charges — What Are These and How Much Do They Cost?
The surrender charge is a fee that you pay when you decide to cancel your annuity. This amount will vary depending on the type of annuity, and it’s typically calculated as a percentage of the premiums paid into the policy.
If you withdraw money from your annuity before a certain time period you may be subject to a surrender charge penalty. The amount of the penalty will vary depending on which type of annuity you have and how long you’ve owned it. In some cases, it is 10% of the amount withdrawn; in others it can be more than that.
A Quick Note About Qualified vs. Non-Qualified Annuities
Qualified and non-qualified annuities differ only in how they are funded: a qualified annuity is purchased with pre-tax funds, while non-qualified annuities are funded with after tax dollars. Qualified annuities can be funded from 401(k) or IRA accounts, while non-qualified annuities can be funded from bank or mutual fund accounts.
Tax Opportunity Costs in an Annuity — What are They and How Much Do They Cost?
Tax opportunity cost is the amount of money that you could have made if you had invested your money in a different way. For example, if you buy an annuity there will be tax opportunity cost because you could have invested that money elsewhere.
Your after-tax dollars that you put in an annuity does grow at a tax deferred rate. However, it may make more sense to fund your 401k prior to purchasing an annuity since these dollars are invested with pre-tax dollars. As you prepare and plan for retirement, it is important to allocate your investment dollars in the most tax efficient means possible.
Tax on Beneficiaries of Annuities — Is it True That the IRS Taxes People Inheriting an Annuity Differently Than Other Inheritances?
The IRS taxes beneficiaries of annuities differently than other investments (like mutual funds). Beneficiaries will more than likely be charged taxes on the gains in the annuity.
Typically, spousal beneficiaries can continue to receive the annuity benefit of the initial contract. However, inherited annuities have different rules. There are generally three options for those inheriting an annuity.
First, there is the lump-sum distribution option. Lump-sum distributions mean that the beneficiary receives the remaining value of the annuity in a single payment. Secondly, if there is a "Nonqualified-Stretch provision in the annuity contract, the beneficiary will receive the payout over the life expectancy of the beneficiary. Additionally, the tax burden is also extended over their life expectancy.
Lastly, the beneficiary may receive the annuity benefit over a five-year period. This withdrawal option pays the beneficiary over five years. The beneficiary can also elect to receive the lump sum in the fifth year.
To determine if an annuity makes sense for your financial situation, it is important to work with a trusted advisor and devise a formal financial plan and strategy. Many investors will often choose annuities due to the guaranteed income stream and the idea that they are safe from market risk. However, this is not always the case. Annuities are complex financial products that can have tax implications, implicit fees and other hard to detect costs. A prudent financial plan can create a saving and spending strategy that does not lock up your money and give you greater flexibility and upside investment return potential.