If you've ever watched daytime TV, you'll see a lot of commercials about annuities, and as such, many believe that they are derived from a settlement of a lawsuit. In cases where an individual is sick or injured and cannot work, sometimes, depending on the circumstances, they will sue a person or a company for additional money to supplement their Social Security payments. Rather than paying out a lump sum to the person, generally the sued company will pay for an annuity instead.
An annuity is a essentially an insurance contract that insures against you outliving your money, versus life insurance which insures against you dying too soon. Insurance companies, generally issue annuities, and in return for a lump sum (money from a lawsuit or saved in retirement), the annuity provider (the insurance company) will provide you with a steady stream of income for the rest of your life. These were meant to replace pension plans or rather provide a way for individuals to receive the same benefits of a pension when their employer didn't provide one.
While that sounds great, there are quite a few things to be mindful of -- namely, annuities are not for everyone and not all salespeople have your best interest in mind (they make huge commissions of the sales of annuities). Before we get into the pros and cons, there are three main issues to be mindful of when investing in annuities:
1) They are often oversold to people who don't need them or understand them
2) Salespeople of variable annuities make huge commissions and generally are pressured to sell annuities to as many people as possible, whether they need them or not.
3) They should only be purchased if they have compelling financial benefits for a individual or a couple, but often this is not fully understood.
The pros and cons listed below were outlined in a recent article from Forbes. Obviously, don't jump to any conclusions and be sure to do your own research and talk to a financial adviser who you TRUST.
Pros of Annuities
- If you are a high-earner in a high tax bracket, low cost variable annuities CAN make sense if you've maxed out your 401(k) and IRA contributions and you expect to drop to a lower tax bracket at retirement.
- They make sense if you can afford to tie up a certain amount of money for an extended period of time (i.e. forever) - If you're concerned about outliving your assets (i.e. if you're very healthy and longevity runs in your family) it makes sense to consider an annuity, and the longer you wait to receive payments, the higher they can be.
- Some government initiatives allow you to put a portion of your 401(k) into an annuity. - If lifetime giving to charities is important to you, you can set up tax-deductible donations that go to your favorite charity while you get to write off these payments on your tax return.
Cons of Annuities
- Variable annuities can be expensive, with annual fees up to 3%-4% and severe surrender penalties if you sell the annuity.
- Some annuities are really complicated to understand and may require the help of an unbiased third party to take a look to see if everything is kosher.
- If you are in a low or middle tax bracket, an annuity with after-tax dollars may disappoint if your income tax bracket ends up as high or higher in retirement due to a) significant RMD distributions from an IRA or 401(k) and b) the fact that tax rates overall likely will rise further in the future.
- It would be better to lock in an annuity when interest rates are higher.
- Once you have an annuity, that money is tied up for life -- if you need that money in the future for something really important (like huge medical bills), be prepared to pay massive surrender charges. - Annuities make poor inheritances since there is no step-up basis to the date of death value.
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