Annuities are hotly debated in the investment world. Detractors criticize their high costs and low returns, while their proponents cite their reliability and estate-planning advantages. The truth lies somewhere in between. They're not innately good or bad, but like any other investment, they must fit your situation. It's important to remember that annuities are best suited for long-term savings. You can't withdraw your money any time you wish unless you're prepared to pay substantial penalties.
How Annuities Work
An annuity is a contract between you and the issuing company, usually an insurer but sometimes it is a financial institution. There are many different kinds of annuities, but fundamentally, they all follow the same basic pattern. You provide the issuer with an investment, either as a lump sum or in the form of regular payments over time. They use those funds to generate an investment return and eventually turn the entire amount into a retirement income for you. They're intended for long-term savings rather than short-term, and most contracts have significant fees for early withdrawal.
Annuities have relatively high management costs because they combine both an insurance and an investment component. Most also pay a significant upfront commission to the broker. The first few years of the contract's life, your payments are mostly directed to paying those costs. If you choose to withdraw some or all or your money from the annuity, the company must make up those costs in fees. They can be as high as 25 percent during the first year or two, and then they decrease over time. In most cases, fees are no longer charged after the seventh or eighth year. A few annuities allow set withdrawals without penalty, so check your contract carefully.
Although your annuity's internal fees diminish over time, the same isn't true of the tax impact. Your money is allowed to grow tax-free as long as you leave it inside the annuity, but that changes when you make withdrawals. Your contributions aren't taxable, because you made them in after-tax dollars. However, the returns on your investment are taxable when you withdraw them. Even worse, they trigger an additional 10 percent tax penalty if you're under the age of 59 1/2.
Stealing From Your Future
With any investment for your retirement, whether an annuity, an IRA or a 401(k), it's important not to think of them as a pool of "my money," just sitting there. Withdrawing those funds to meet a short-term need means stealing from your own future. If someone broke into your home and stole $30,000, you'd likely be upset. Yet, you're doing much the same thing when you make a withdrawal from your retirement savings early. Don't do it without exhausting your other options first.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.