What are the potential pitfalls of annuities?

Although annuities have their advantages, in terms of tax-deferred growth and an unlimited contribution levels, annuities also have a number of pitfalls that you must be aware of before you opt to purchase an annuity. If you rely on annuities as an estate or retirement planning tool, you may encounter limited investment opportunities, high costs and fees, an uncertain death benefit, and unwanted tax implications.

Many insurance companies that offer annuities have only extremely limited investment opportunities. As a result, you may not have much choice in how your money is invested; furthermore, this fact may result in a decreased likelihood of growing your investment to the level that you need in order to plan for your future needs, as well as those of your family. However, there are larger financial planning companies that allow you to choose from a menu of mutual fund accounts, which are called “subaccounts”. If you are able to make such an investment through your annuity, then you may be more likely to see the rates of return similar to regular retirement accounts, such as 401(k) plans and individual retirement accounts (IRAs).

Unfortunately, the vast majority of annuities also come with rather high money management expenses and annual fees. The average annual expense of owning an annuity is 2.4.% of the amount of the assets held, which is very high compared to investments in IRAs or 401(k) plans, for example. Likewise, surrender fees for annuities are high, especially if you need to withdraw funds within the first five years after purchase, although the fees do tend to decrease as time goes on. For instance, if circumstances cause the need for you to withdraw funds prior to reaching age 59 ½, you can face not only surrender fees, as well as substantial tax penalties.

While annuities have certain advantageous tax implications, such as the ability of your investment to grow tax-deferred, annuities also have some tax implications that may not be so advantageous. Annuities, like mutual funds, are subject to federal estate tax laws, if they fall outside the $2 million estate tax exemption. Thus, if your beneficiaries inherit your annuity, they also inherit the income taxes owed on the amount of the annuity, in addition to any applicable estate taxes. Plus, as noted above, if you must withdraw money from your annuity early, or prior to age 59 ½, you can face a 10% tax penalty for your early withdrawal. In some situation, you can even be hit with a 25% tax penalty.

Another much-advertised advantage of annuities is the death benefit feature. Unfortunately, the “guaranteed” death benefit is not always a sure thing, in that it typically expires when you reach a certain age, which is usually around 75 years of age. Once you reach that age, there is a no longer a guaranteed death benefit available to your beneficiaries. Furthermore, even if your death benefit is intact at the time of your death, the only guarantee of this death benefit is that your beneficiaries receive the amount that you invested originally into the annuity. Compared to a regular mutual fund account, which, on the average, earns about 12% interest annually, this is not an advantage for your family, unless you die very soon after purchasing the annuity.