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The Downside of Annuities (Part 1)

While an annuity can be a useful part of a retirement plan, the term “Variable Annuity” has become a dirty word in regulatory circles in recent years.  There have been thousands of cases of people, particularly seniors, being talked into variable annuities that were completely inappropriate for them.

In 2009, a class action lawsuit against nationally-known insurance company Allianz alleged that some 340,000 people were sold risky variable annuities, and were misled by slick sales reps about the underlying terms and penalties of these annuities.  They earn fat commissions on the sales of these products, so the incentive to sell – and the pressure they put on you to buy – is huge. Here are some things to watch out for if you’re being pitched this kind of product.

Surrender Penalty.  The insurance companies who sell annuities don’t make any money if you’re able to pull the funds out whenever you want.  So they tack on a “surrender penalty,” a percentage that the company deducts from your account if you close your account sooner than they would like.  Read the fine print – you may have to wait three, five, seven years or more before you can take your money out without giving up a big percentage of it to do so.  That means, if you’re unsatisfied with the annuity company, or if you have a financial emergency and need cash, you lose out big time.  And depending on your age and life expectancy, what are the odds that you will outlive that surrender period?

In the Allianz case, the annuitants alleged they were promised an “upfront” bonus for purchasing the annuity that would offset the surrender penalty.  The annuitants claimed, however, that Allianz was not on the hook for this bonus for fifteen years, and for some annuitants, the bonus never materialized.

Taxes.  Annuity salesmen emphasize that these products grow tax-deferred, and that’s true.  While your money is locked up in the annuity, you pay no taxes at all.  Once you begin taking withdrawals, you pay taxes on the earnings portion of your annuity.   But these earnings are taxed as income at your income tax rate.  By contrast, were you to put your money in a mutual fund on your own, the earnings would be taxed each year as capital gains at just 15%.  If you’re in a tax bracket higher than that, having your money in an annuity has actually cost you more in taxes.

The next post will address further red flags of variable annuities.

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