Annuity Investment: Does It Make Sense For You?Posted on August 28th, 2010 William No comments
These days a lot of people are interested in adding an annuity investment to their portfolios. We previously discussed how annuities work; today we'll talk more about deciding if an annuity is right for you.
Annuities are similar to whole life insurance (which we never recommend) in that they mix an investment with an insurance component. Normally we recommend keeping the two separate - buy your insurance where it makes the most sense and invest your money where it makes the most sense. However, we're normally concerned with insuring health or property. Annuities are something different - they insure against longevity.
This seems like a strange thing to say - why would you want to bet against living a long time? The trouble with many people's retirement planning is they set up their investments to give them enough money to live for a few decades after they retire. Unfortunately, if their investments don't do as well as planned, or if they live longer than expected, they find themselves running short on money. An annuity is protection against that: you can have guaranteed income that will last for as long as you live.
Annuities also ensure that you won't lose money, but this is generally not a major draw for long term investors as a properly diversified portfolio should make money in the long run, and annuities are not attractive to short term investors due to the surrender charges, as discussed below.
There are two types of annuities, variable and fixed; we prefer fixed annuities because they tend to have lower administrative fees. In a variable annuity, you're making investment decisions rather than just earning a fixed rate, and you can end up paying up to two percent in fees each year, which creates a massive drag on your return.
One thing to consider before buying an annuity is whether there's any chance you'll need to withdraw the money. Removing money from your annuity in the first six to eight years incurs a surrender charge of up to eight percent. If you're investing money that you could potentially need to get to, you're much better off with a Roth IRA, which allows you to withdraw up to the amount deposited with no penalty. Of course, you should probably be maxing out your IRA (and other tax-preferred retirement plans) before considering other investments anyway.
So when should you consider buying an annuity? If you have sufficient income that you were able to max out all of your other retirement plans, annuities are nice because there's no limit on how much you can contribute. Additionally, if you make a lot of money you may not be eligible to contribute to other retirement plans; annuities have no income restrictions. They can also be a good idea if you expect to live a long time, as they essentially pay you a premium for beating your life expectancy.
Don't buy an annuity if you have places you can invest with pre-tax dollars or if you might need to get your money back in the near future. Also, beware that while your investment will grow tax-free, when you start taking disbursements they are taxed as ordinary income, so you'll likely pay more in taxes than you would if your money was tied up in something where the return is treated as capital gains.
Consider your circumstances carefully before deciding whether an annuity investment is right for you.