When to Consider
and When to Run From Annuities

Good Morning Relaxing Retirement Member,

As promised last week after the questions I received, I’m now going to give you some examples of situations where I believe you should run away from annuities when they are being proposed to you, and some situations where an annuity might be something for you to consider.

Before addressing situations where I believe annuities are grossly oversold, here are the three situations where annuities might be appropriate for you as long as you do your proper research before signing on the dotted line.

1.  Tax Deferral

If you have funds held outside of your IRA, Roth IRA, and/or employer sponsored retirement plans that currently earn interest, dividends, and/or capital gains that you’re not currently spending, an annuity can be used to defer income taxes until you need the money to spend.

There are three potential benefits of doing this:

  1. Deferring the Tax: You control “when” you pay the tax. By doing so, you can benefit from compound interest on the balances that would have gone to taxes if held outside of the annuity.
  2. Taxes on Social Security Income: The amount of tax you pay on your social security income is in direct relation to the amount of income you receive in addition to social security. The lower the amount of your other “provisional” income, the less of your social security income that is subject to tax.

    If you currently have interest, dividends, and/or capital gains coming from investments which you’re not spending, using an annuity to defer the taxes on those items not only reduces your taxes on that interest, but it may also reduce the amount of tax you must pay on your social security income.

  1. Medicare Part B Premiums: As many of our Relaxing Retirement members have learned, your Medicare Part B premiums you pay are based on the amount of income on your 1040 tax return the prior year.

    Like the example above, if you reduce your taxable income, you may qualify to pay a lower Medicare Part B premium.  One tool to reduce your taxable interest, dividend, and capital gain income is a tax deferred annuity.

There is a downside to this tax deferral strategy, however, which you must know going in.

All money withdrawn from a tax deferred annuity over your initial investment are considered “ordinary income” and thus taxed at ordinary income tax rates.

For example, if you deposit $100,000 into a tax deferred variable annuity and it grows to $150,000, you will pay ordinary income tax rates on the $50,000 of growth when you withdraw the funds.

If you invested in a traditional mutual or exchange traded fund held outside of an annuity or IRA and the value increased from $100,000 to $150,000, you would pay “capital gains tax rates” upon the sale.

This is significant because federal ordinary income tax rates can be as high as 37.0%, whereas capital gains tax rates top out at 20%.

If the investments you will own inside the tax deferred annuity will qualify for capital gains tax treatment, you have to strongly weigh the long term tax deferral benefits vs. the higher tax rate you and your family will pay upon withdrawal.

2. Tax Free Exchange From Life Insurance

If you currently own whole life insurance (that you’ve determined no longer need) with significant cash value, you may have a tax problem when/if you cash in your policy.

To the extent that your cash value is greater than the premiums you’ve paid over the years, you will owe ordinary income taxes.

In other words, if you have a policy with a cash value of $100,000 and over the years, you’ve paid a total of $60,000 in premiums, when you surrender your policy, you will owe ordinary income taxes on the difference, i.e. $40,000.

A way of deferring this tax burden is to directly exchange your life insurance policy’s cash value into a tax deferred annuity.

By doing this, there’s no tax burden at the time of the exchange and you get to continue tax deferred growth on your funds until you choose to withdraw funds.

2. Annuitizing

Annuitizing simply means turning your savings into monthly income for a stated period of time, typically for life.

  • Covering a Specific Expense: While this would never be the situation a Relaxing Retirement member would find themselves in, if social security is your only source of guaranteed monthly income, and you have a specific bill that must be paid each and every month, consider funding an immediate annuity.  Structure the amount of the payment to you to cover that expense for the period of time the expense exists, i.e. a mortgage.
  • Medicaid Planning: It would be impossible to cover all the issues concerning qualifying for Medicaid in this edition.  However, as we reviewed recently, in the big picture, if you have assets above a very minimal level, you will not qualify for Medicaid assistance to pay for your care.

    One strategy used by many elder law practitioners is to move current assets into an immediate annuity.

    In the eyes of the federal government, once the funds are deposited to the immediate annuity, the asset no longer exists.  Only the income from that asset which significantly increases your chances of qualifying for Medicaid assistance.

    However, the same warning that I’ve raised still applies here.  Remember that when you annuitize, you give up access to your money other than receiving your monthly income.  When you and/or your beneficiary pass away, the insurance company keeps the money.

  • Guaranteed Income: If you want some portion of your monthly income guaranteed, an immediate annuity can accomplish this.

    Two caveats come with this, however.  The first I just alluded to which is to remember that once you annuitize, your asset is turned over to the insurance company.

    The second is inflation.  With most annuities, the payment is guaranteed for a certain period of time, typically for life.  However, there is no cost of living increase each year to keep pace with inflation.  So, if your monthly payment is $2,000 per month, 10 and 20 years down the road, you’re still going to receive $2,000 per month even if inflation has decreased the value of that $2,000.

Now let’s take a look at situations where I believe annuities are being oversold.

1. Buying a Variable Annuity “Inside” of Your IRA or Roth IRA

As was the case with the story of the brother of an existing Relaxing Retirement member I shared with you recently, a classic example of a situation I see way too often that I don’t recommend is investing in a variable annuity inside your IRA or Roth IRA.

As I outlined above, one of the benefits of an annuity is tax deferred growth of your money.  However, all investments held inside of an IRA or Roth IRA grow tax deferred already.

Given this, why would you need to place a tax deferred vehicle (annuity) inside of a tax deferred vehicle (your IRA)?  An example of this is rolling over balances from your retirement plan at work, i.e. your 401(k), 403(b), or your pension plan into an IRA and investing in an annuity inside your IRA.

Although sellers of annuities tout all the bells and whistles of complicated annuities, there really is no valid reason to invest in one inside of an IRA.

Unfortunately, one of the main reasons why it’s recommended so often is the commission paid on an annuity vs. an alternative.  With the exception of a few no-load annuities now being offered, fixed, variable, and equity indexed annuities typically pay much higher commissions, so there’s a significant incentive for a broker to sell an annuity instead of just a mutual fund or an exchange traded fund.

All things being equal, this alone would not be a profound problem.  However, in order to pay those higher commissions, the insurance company sponsoring the variable annuity must charge you higher fees!

For this reason, I do not recommend this practice.

2. Equity Indexed Annuities

During volatile financial markets, products are created and heavily marketed which appear to be “one-size-fits-all” solutions.

In my opinion, equity indexed annuities fall into this category.  Their promise is to allow you to invest in stocks (using one or more indexes, like the S&P 500), yet not lose any money personally if the market index goes down.

When you first hear the concept, it sounds extremely attractive.  In short, they propose that you will receive the upside benefits of investing in stocks without the downside risk!

However, as with most financial instruments, you have to read the fine print.

Insurance companies do place a floor on your deposit so that when you withdraw funds from the equity indexed annuity, you will receive no less than you deposited.

However, a few key points to note:

  • If you withdraw funds over the first 10 to 25 years, you have to pay a stiff surrender charge for access to your money. And, I’ve seen that charge be as high as 15%.
  • Your upside potential is limited. If the S&P 500, or whatever index your annuity is tied to, earns 10%, you don’t get credited with a 10% gain on your equity indexed annuity. Your gains are capped at a much lower percentage and the insurance company keeps the rest.
  • There is a high price to pay for this “guarantee”. If you break open these complicated products, you will discover that you are paying significant fees to the insurance company to provide their guarantee, and to pay commissions to the broker who sells the equity indexed annuity.

Without knowing any more, if you objectively stand back and examine this product, you have to ask yourself how the insurance company can take on this exposure and not have a problem down the road.

In 2008, for example, when the S&P 500 Index dropped over 37%, how did their company stand up when they had to guarantee no losses to their equity indexed annuity customers?

How are they going to keep that promise indefinitely if the stock market doesn’t cooperate and there is a run on annuity deposits from their customers?

For this reason alone, I’m not a fan of equity indexed annuities.

To sum up, I do believe there are very limited situations which warrant using an annuity as long as you do so with your eyes wide open.  I simply believe that those situations are much, much more narrow than those currently being sold today.

Homework Assignment

Once you’ve digested these last few editions of The Retirement Coach Strategy of the Week dissecting annuities, and your interest is peaked, here are just a few more recommendations for you before considering using an annuity:

  • Access to Your Money: Be very clear on the language of the insurance company’s surrender charges when you need access to your money. This is critical.  There are companies who have no surrender charges when accessing your money.
  • Insurance Company Ratings: With fixed annuities specifically, be careful to examine the independent ratings of any insurance company you’re considering.  Remember, how well you do is directly tied to the performance of that insurance company.
  • Fees: Specific to variable annuities, be very clear what their insurance charges are to run the annuity, typically 1.50% or so.  If a variable annuity is what you’re after, a few companies now have very low cost variable annuities.

I hope this has been helpful for you.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)