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As with any type of investment, annuities are not for everybody. Every investment vehicle contains characteristics that may or may not match your own objectives, preferences or risk tolerance. The advantages of annuities may work for some people, but not for others. There are certain disadvantages that may preclude a certain type of investor from choosing it as an alternative.
For your own evaluation of annuities here is a list of their pros and cons:
Annuity Pros Fully Explained
- Taxed deferred accumulation: The earnings inside of annuity are allowed to accumulate without paying current taxes enabling them to grow faster. This is an advantage for investors in higher tax brackets.
- Competitive interest rates: Fixed annuities pay a rate based on yields generated from a life insurance company’s own investment portfolio and they tend to be higher than equivalent savings or investment vehicles such as bank CDs.
- Minimum rate guarantees: After the initial interest rate guarantee expires, it is adjusted to the current market rates which could be higher or lower, but never lower than the minimum rate stated in the contract.
- Safety of principal: In fixed annuities, the principle balance is backed by the assets of life insurance companies. Because life insurers must meet stringent reserve requirements imposed by the states, the likelihood of a default is very minimal. The highest rated life insurers are deemed to be the safest of all financial institutions.
- Access to funds: Annuity contracts allow for an annual withdrawal of up to 10% of the account balance without any charge.
- Guaranteed lifetime income: The one investment objective annuities can achieve that no other vehicle can is to provide a secure stream of income that a person cannot outlive.
Annuity Cons Fully Explained
- Taxable Withdrawals: At some point the IRS is going to want its money. Since annuity earning accumulates tax deferred, they are taxed at the time of withdrawal as ordinary income. This may work out to the advantage of those whose tax brackets are lower in retirement than during their earning years.
Penalty for early withdrawals: For the privilege of deferring taxes on earnings, the IRS will penalize any withdrawal made prior to age 59 ½. An annuity can be converted to a stream of lifetime income at any time (referred to as annuitization) which means you can begin to receive periodic payments without incurring a penalty.
- Surrender fees: While annuities allow for access to account balances, there is a charge when the withdrawal exceeds 10% of the balance in a year. The fees start out fairly high (7% to 15%), but they decline by a percentage point each year until they vanish which usually coincides with the end of the surrender period.
- Fees and expenses: One of the criticisms leveled at annuities is that they are generally more expensive to buy and maintain as they have fees and expenses not found in other types of investments. Fees are deducted from your account balance each year to cover mortality costs and administrative expenses. Also, some annuity products are sold with a sales load or commission. There are hundreds of annuity products that can be compared to find those with the lowest expenses and low or no sales loads.
In general, annuities are best suited for people with a long term time horizon, who could benefit from tax deferred growth on their funds, and who are particularly concerned with safety, stability and future financial security. One way to evaluate annuities as a possible investment choice for your own situation is to consider each of their main features and then determine if, in your particular situation, it is an advantage or disadvantage.