Tax law changes, safety, attractive yields and a search for alternatives to individual retirement accounts have sparked a boom in sales of single-premium fixed annuities. But while these investments can be attractive as a long-term savings vehicle for conservative investors, be wary of high withdrawal charges and other drawbacks.
Single-premium annuities basically are investment contracts sold primarily by insurance companies that provide you or another beneficiary with income for retirement, in exchange for an initial investment, usually at least $5,000.
The most popular type are fixed annuities, which put your initial contribution into conservative investments such as bonds and mortgage-backed securities. They currently are paying initial annual yields of as high as 9.5%, although more typically they are between 8% and 9%.
Less popular, but more adventurous, are variable annuities, which invest your money into stocks, bonds or mutual funds. Because of their greater volatility, their returns vary widely. And their annual fees tend to be higher than on many mutual funds.
Here's how a typical fixed annuity might work: You are 50 years old and make an initial investment of $5,000. Your annuity grows to be worth $17,000 at age 65. With that you could receive monthly payments of $150 for 10 years, says Glenn S. Daily, insurance analyst at Seidman Financial Services, a financial planning firm.
Alternatively, he says, you can take the money in a lump sum, as many annuity holders do, or designate whatever period you wish to receive payments.
One of the chief advantages of fixed annuities is their relative safety. "As a practical matter, the risk of losing your principal is very slim," Daily says.
Another advantage: Taxes on your investment gains are deferred until you withdraw your money. If you hold the annuity for a long time, that tax deferral can make the return on an annuity superior to returns on certificates of deposit, money market funds, Treasury securities or other investments that are taxable every year.
Daily estimates that an annuity earning 8% and held 10 years will yield half a percentage point more per year, after tax, than a 10-year CD paying the same rate, assuming you are in a 30% tax bracket for combined federal and state taxes. The annuity advantage rises to 1 percentage point per year if held for 20 years, he says.
The tax deferral feature makes annuities similar to IRAs in which you cannot deduct your initial investment. With annuities, however, you can invest much more each year than in IRAs, depending on what the insurer allows in the contract. IRAs limit your annual contribution to no more than $2,000.
Also, with an annuity, you may not be required to withdraw money until you are between 85 and 90 years old, Daily says. That gives you far more flexibility than an IRA, which requires you to take out certain minimum amounts when you hit age 70 1/2.
Annuities also got a boost recently by a new tax bill passed by Congress last month. The bill reduced the attractiveness of single-premium whole life insurance, putting it roughly on an equal tax footing with annuities.
Annuities should offer superior investment returns to single-premium whole life insurance, Daily says, because part of your investment in the whole life insurance product is going to provide the death benefit.
With these advantages, sales of single-premium annuities are expected to hit a record this year, according to the Life Insurance Marketing and Research Assn.
But before jumping into an annuity, be sure you know the drawbacks.
First, the high initial yields can drop. Most annuities will guarantee initial rates for only one to three years; after that they can fall yearly at the discretion of the insurer. Guaranteed minimum rates are sometimes as low as 3%.
Also be wary of high surrender charges--fees you pay if you close the annuity and withdraw your money. These charges can start as high as 7% of your investment in the first year, tapering off the longer you keep the annuity.
Perhaps the biggest drawback is that you must pay a 10% penalty tax if you withdraw funds before age 59 1/2, just as in an IRA. That penalty can wipe out any advantage that annuities have over CDs or other investments, Daily says. And any accumulated untaxed gains are subject to ordinary income tax whenever you withdraw them.
Accordingly, experts advise, buy an annuity only as a long-term vehicle for retirement savings. For short-term gains, you are better off investing directly in Treasury securities, money market funds, savings accounts, short-term bond mutual funds or other low-risk vehicles.
How do you shop for annuities?
Unfortunately, it's not easy to comparison shop. Information about performance records of various insurers is hard to obtain, Daily says. You may have to call insurers yourself.