Should I Invest in Annuities

Annuities are designed to meet the needs of a number of financial situations. You can select annuities that have flexibility in how and when you put money in, the methods for taking money out, and how you contributions are invested during the term of the contract.

Contributing to an Annuity Contract

There are two methods of putting money into an annuity contract. The method used depends upon how much money you have to invest now.

The first method is putting one large sum at one time. This is called a single premium or lump sum annuity. You may use this approach if you come into a large amount of money such as an inheritance, and you are buying the annuity primarily for tax deferral purposes.

The second method is periodic contributions. You would put in a certain amount each month and then start receiving your payments out when you retire. You would use this method when putting a portion of your salary aside each month to save for retirement

Type of Annuity Contract

There are basically two forms of annuity contracts. These are the fixed annuity contract and variable annuity contract.

With a fixed annuity contract, your contract earns a specific interest rate for a specific period of time such as 3 years or 5 years. After that time, the interest rate is set for the next period. Your principal and interest are always guaranteed against loss by the insurance company. So, a fixed annuity is similar to a bank CD. However, the guarantees are made only by the insurance company and you are not covered under any type of government insurance such as the FDIC. If the insurance company should become insolvent, your annuity is as risk.

Under a variable annuity contract, you can make the same types of contributions as under a fixed annuity. The insurance company guarantees that it will make periodic payments to you later on. The difference is can be found in how money accumulates in the contract. Your contribution does not go into the general account of the insurance company. Your money is invested in in one or more mutual funds that you select as your investments. You may have a choice among a number of mutual funds to match your investing style and goals. These will include both stock and bond funds. The amount of your eventual payout will depend upon the investment performance of the funds you selected.

Advantages of Annuity Contracts

The main advantage of all annuity contracts is that all taxes on your earnings are deferred until you withdraw money from the contract. This is a huge advantage over putting your money directly into mutual funds, where you would be taxed each year on earnings, assuming the money is not covered under an IRA, 401k, or other retirement plan.

Insurance company guarantees are the next advantage of an annuity. Under a fixed annuity, your money is guaranteed against loss at all times. You are also guaranteed to receive a set benefit for life in retirement. Also, you are usually guaranteed a death benefit to your beneficiary.  Under a variable annuity, the insurance company guarantees to make payments though the amount varies with the underlying investments you chose. You can also add contract riders to provide any additional guarantees you might desire. One of these riders is a minimum return guarantee on your investments. Of course, adding in these riders come at a cost. Variable contracts also provide for death benefits most of the time.

Disadvantages of Annuities

Insurance guarantees come with a cost, both in dollars and flexibility of what you can do. Rather than just list the disadvantages, let’s compare investing in an annuity with putting our money in a mutual fund, outside of your 401k or IRA.

Annuities give you a choice of a guaranteed income for life under various options. You receive a small payment per month compared to your overall account balance.  This scenario turns off many people who hesitate to commit such a large amount of money. It really comes down to your having to decide how long you expect to live. Then again, that is the purpose of an annuity; to ensure you do not outlive your money.

You are making a long term commitment with your money. In order for the insurance company to make guarantees, they need to control the assets. Therefore, you have very little flexibility after you make the commitment. You also cannot undo the commitment should your situation change later on.

In fixed policies you get a guaranteed interest rate. In saving for the long term, such a fixed interest rate may not allow you to earn enough to outpace inflation and give you a comfortable retirement. With a variable annuity, you do have the ability to participate in the performance of stock and bond mutual funds. However, you also have the ability to choose the wrong funds, and change funds at exactly the wrong time in a given economic environment. However, you have the same investment responsibility under a regular mutual fund. You are the one that must make the investment choices.

Fees, commissions and cost of guarantees are the factors that turn off most financial planners. These factors can be high in fixed annuity contracts and very high in variable annuity contracts. The expense factors must be carefully weighed when shopping for an annuity. Much less fee levels exist under mutual funds, which is why financial planners favor these types of investments. However, your financial planner is not the one who will have to deal with the insecurity of not having a guaranteed annuity at retirement. Having an annuity will give you a much more secure feeling when you know your payments will be coming in for life.


In an annuity, your investment earnings, either fixed or variable, will be taxed as ordinary income when you withdraw money. When you withdraw money from a mutual fund, your earnings are taxed as capital gains. Ordinary income is taxed at a higher rate than capital gains on your tax return.

If you should die, your annuity earnings are taxed to your beneficiary when he or she starts taking withdrawals. The IRS views your earnings as being passed to your beneficiaries and so they must pay tax on these earning when they receive withdrawals. Under a mutual fund, your beneficiary inherits your money at current value tax free. Your assets receive what the IRS calls a Step-Up in cost basis as though your beneficiaries had bought these assets at the value when you died.

Withdrawals from an annuity are taxed as though you are taking out earnings first. In other words, you will be fully taxed on all withdrawals until your balance gets down to the amount of contributions you put in. Then further withdrawals will be tax free. Withdrawals from a mutual fund will be taxed as though you took out your own contribution first, and then your earnings. So, you won’t start to be taxed until you take out all of your contributions.

Your Own Financial Situation

Taxes upon withdrawal may or may not be a big consideration for you depending upon your situation. Are you concern with the effect of withdrawals for you beneficiaries? Do you plan to make withdrawals in a lump sum? Do you want or need the tax deferral advantages of an annuity? All of these factors go into your decision.

No two financial situations are alike. Your situation and priorities will be much different than your neighbor’s. You need to look at how much you have in various retirement accounts and compare that to your expected expenses when you retire.

If you are covered under a defined benefit pension plan you will be receiving a portion of your overall retirement payments in the form of an annuity. In this situation, I would suggest you look to maxing out your IRA and 401k, and then putting further contributions into assets outside of an annuity.

If you are not covered under a defined benefit pension plan, you are going to experience certainlevel of insecurity in retirement regardless of how much money you have. This is because you will have no guaranteed payments coming in. Ask any retiree and he will tell you his number one fear is outliving his money. An annuity can alleviate some of this fear.