An annuity contract is a financial product sold by insurance companies. There are several different types of annuities contracts, but the basic idea is the same. You agree to pay a specific amount of money, either up front or over time, and in return the insurance company promises to make regular payments back to you. These payments can begin immediately or at some set date in the future, and continue for a specified period of time. The goal of any such contract is to provide oneself with a source of steady, long-term income.
The insurance company then invests your money and promises to make fixed payments to you for a set period of time. Depending upon the type of annuity you choose, this fixed payment (called a distribution) can be a set amount or a preset percentage of the gains made on your money each year.
Benefits of Annuities
There are some benefits that come with purchasing an annuity contract, but there can also be drawbacks. One must carefully weigh out these pros and cons in order to determine if an annuity is right for them.
The primary advantages of annuities are twofold: 1) They offer a guaranteed return on your money regardless of how the underlying investments perform and 2) They can offer various tax-deferral advantages – much like a 401(k).
It is important to have a good grasp on the fees involved with annuities. Many people are not even aware of the fact that a sales commission is paid to their broker when they buy into an annuity. What’s more, this commission is one of the highest paid out for sale of a financial product – generally averaging 5% to 6% or higher.
The insurance company that holds the contract may also charge several other types of fees for the administration of your account. It is important to carefully scrutinize the disclosures related to fees to make sure you are getting the story straight, as they can sometimes be hard to decipher.
Almost all annuity contracts carry with them a surrender period which ranges anywhere from 3 to 15 years. This means you agree not to withdraw your money for that period of time. Some contracts will allow you to withdraw a small percentage of your money each year but will impose a surrender charge on any money withdrawn above the allowed percentage. Surrender charges can be between 7% to 30% of your total portfolio value.
Beyond the surrender period, the government imposes a 10% penalty tax on any money withdrawn before you have reached the age of 59 1/2. You may also have to pay a State Premium Tax of as much as 2.5% on your initial investment upon closure of the account.
Limiting Your Gains
As we have already discussed, an insurance company offering annuities will pay a commission to a broker for selling you a contract. They may also charge an annual management fee. Further, insurance companies generally invest these monies in mutual funds. Those mutual funds charge their own management fees, and these fees also come out of your invested money.
Are Annuities Right for You?
There are instances in which purchasing an annuity contract can be the sensible thing to do, but it is important that one know all there is to know before making such a commitment.
Our top investment advisors can help you analyze your situation and determine whether investing in annuities is right for you.