There are two types of annuities: immediate annuities and deferred annuities. Immediate annuities start paying an income stream for a fixed life expectancy or a certain period. Deferred annuities are used to invest assets in a tax-deferred environment until your client reaches retirement or until the insurance company requires a payout, or annuitization, often by age 85 or 90.
Within each type of annuity is a fixed or variable option. Fixed generally means the insurance company dictates what the yield will be or that the yield is tied to an index, such as a stock market index. Variable annuities are securities products, also known as investments, because the underlying returns are determined by the investment choices made by the client. The choices range from guaranteed interest rate accounts to equity sub-accounts with substantial volatility.
It's great when an annuity is appropriate for the client. But when an annuity turns out to be a bad recommendation, you risk far more than just losing the client.
Tax benefits
The pluses touted by annuity companies are abundant. The most revered is the tax deferral. For a fixed annuity, the tax deferral can make sense as long as the client does not need the interest. If the money is not going to be spent in the near future and the interest would otherwise be compounded in a taxable investment, the tax deferral is worth it as long as the yield is competitive. There is another advantage of the deferred yield for lower-income taxpayers in a reduction to adjusted gross income (AGI), which may reduce or eliminate taxation of Social Security earnings.
The disadvantage of the deferral has to do with tax brackets. If your client knows that this annuity may be used in 10 years to buy a second home, then all of the deferred interest will be taxed upon withdrawal. While the tax rates 10 years down the road are unknown based on today's rates, this may cause "bracket creep" for your client. This means the ultimate tax bill may be far greater than it could have been had they paid the tax from a taxable investment every year in a lower bracket.
For a variable annuity, the deferral may actually be a liability in the long run. Again, we can't forecast income tax and capital gains rates, but if we use today's rate structure as the assumed rates for the forecasted period, the results may not be pretty. Today, the maximum capital gains tax rate is 15 percent with the maximum income tax rate at 35 percent. Distributions from a variable annuity will trigger ordinary income vs. capital gains if a similar, taxable investment period was chosen. Before the recent reductions in capital gains rates, an argument could be made that the deferral still outweighed the higher tax rate after about 15 years (depending on the income tax rate of the situation in question), but today that breakeven holding period is likely to be much longer.
The guarantees
Another advantage of annuities is the guarantees. In immediate and fixed deferred annuities, insurance companies promise to pay a stated rate or an income for a stated period. This is a contractual obligation that is weakened only by the failure of the insurer. Variable annuities -- which used to have only the death benefit to make certain a survivor was made whole if the investment declined in value -- now offer many guarantees for investors.
Companies are announcing enhancements to their living benefits and developing new bells and whistles daily to differentiate themselves from their competitors. Nevertheless, guarantees are powerful things. Many clients love them, want them, and are willing to pay for them. For years, many professionals avoided annuity discussions because of the expenses and other limitations without realizing just how important those guarantees are to some clients.
Annuity disadvantages
There are two sides to every story, and annuities definitely have some disadvantages. One of the disadvantages is surrender penalties. Not only is it aggravating to some clients that there are surrender penalties at all, but some linger for many years -- even forever. If an annuity with a longer surrender penalty period had lower fees and expenses to net a higher yield for the client, that would be one thing. But if the longer surrender period is only to the benefit of the agent or the carrier, that does not reflect well on the industry.
Another disadvantage is fees and expenses. In a fixed deferred annuity, this may not be a major issue. If it is easy for the client to see what the yield will be for the first and subsequent years and if they are comfortable with that guaranteed rate, then presumably they are OK with the fees. But the fees are far from transparent and a bit of a black hole that insurers may have to deal with in the future.
Another negative aspect of annuities is their complexity. Besides being driven by huge commissions and very long surrender periods, the index annuity market can be too complicated. Most professionals prefer index products that are simple and have the fewest moving parts, lowest fees, and reasonable surrender periods.
Fees in a variable annuity can get extremely steep -- upwards of 4 percent annually -- if your client buys all of the guarantees offered by the issuer. Many investors find value in the opportunity to not lose money, get a predictable stream of income, or increase the death benefit to compensate for the income tax costs on death.
John P. Napolitano, CPA, PFS, CFP, MST is chairman and CEO of U.S. Wealth Management LLC. For more information, call 781-849-9200, email jnap@cpafp.com, or visit www.cpafp.com.
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