An annuity isn’t a mutual fund that you buy today and sell tomorrow. Nor is it a certificate of deposit, ready to be used at maturity. When you buy a tax-deferred annuity, you are making a 15 to 25-year commitment at minimum.
That’s because you could have chosen to buy those same mutual funds outside the annuity, in which case you’d have paid lower fees and lower taxes on your capital gains. It takes 15 to 25 years for the value of the annuity’s tax deferral to overcome the disadvantage of its higher costs, and that’s in higher tax brackets. In the lower tax brackets, it might never catch up.
Read that again, if you are in a lower tax bracket, buying an annuity is just a bad idea as the tax advantages you might never see. Discuss with your CPA to ensure you are making the right decision based on your current level of net income and tax bracket.
- Buy fixed annuities if you’d otherwise keep the money in a bank account and the annuity pays the same or more than a certificate of deposit. You’ll earn the interest tax-deferred.
- Buy immediate-pay annuities late in life if you start worrying that you might run out of money. The annuity guarantees you an income for life. That is a HUGE advantage.
- Buy low-load tax-deferred annuities if you’re in your early 50s or younger and won’t touch the money for 30 years. (But only after you’ve fully funded your 401(k) and opened a Roth IRA if you’re eligible.) If you choose the annuities sold by commissioned brokers, planners, and insurance agents, buy no later than your early 40s.
- You need an extended holding period to overcome their high costs and tax disadvantages. When choosing among low-loads, look for the one with the highest guaranteed minimum rate.
- Buy low-load tax-deferred annuities if you have young children, not to be touched until they retire.
- Do not buy full-sales-charge, tax-deferred variable annuities if you’re in your 50s or older—which happens to be the ages that salespeople target. You’re effectively buying mutual funds at an excessively high price and will pay higher taxes on the gains.
- Do not be seduced by the extraordinary, guaranteed income benefits attached to variable annuities. The sales pitch suggests that your income from the annuity will rise in your later age. On paper, it can. In real life, it’s highly unlikely because of the actual annuity costs are so high. The odds are, you’ll wind up with a fixed income instead. To make matters worse, your income will be lower than if you had bought a simple, fixed lifetime annuity in the first place.
- Do not be seduced into buying a deferred annuity because you can turn it into a lifetime income later in life. You don’t need a deferred annuity for that purpose. You can buy a lifetime income whenever you want, with savings that you build up somewhere else. The annuity strategy makes sense only if you’re in a high tax bracket and are investing assets that would otherwise be taxed at your ordinary income rate and know that you’ll annuitize when you retire.
- Use the free-look period. If you have an aggressive sales agent that talks you into buying an annuity and then have second thoughts, you typically have ten (10) days or more to rescind the sale without paying a surrender penalty. Don’t hesitate to do so.
Laura Bushnell is Editor in Chief for National Review Brand Foundation of Consumer Updates and based in Boston. Previously, she held senior VP level positions in corporate finance and consumer financial planning firms.