Fixed Annuity Pitfalls

An Overview

Annuities have gotten a bad rap for having hidden fees. It's true, fixed annuities have their pitfalls, as does any investment, but most of these problems are easy to avoid for wary investors:

  • Don't invest in fixed annuities with cash you'll need tomorrow. Your premium is safe, but early withdrawals are subject to fees.
  • Investing Too Young: You'll be charged a 10% IRS tax penalty on income withdrawals made under the age of 59.5.
  • Guaranteed rates don't always last the full contract term. A 10 year annuity might guarantee an 8% rate, but only for 6 years. Ask how long the guaranteed rate lasts.
  • Withdrawal Charges: Early withdrawals from a fixed annuity can be subject to fees. Look for "No-Load" annuities.
  • Interest-Only Penalty-Free Withdrawals: Annual penalty-free withdrawals might exclude principle.

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The Biggest Pitfall: Investing Short-term

By far the greatest annuity investor pitfall is investing money you'll need tomorrow. Annuities are retirement savings vehicles much like a 401(k) and should not be invested in short-term. Because they aren't as liquid as mutual funds or money market accounts, you should only invest nest-egg money.

Buying immediate fixed annuities is an exception to this rule because you'll be receiving a guaranteed monthly income. Before you invest, just be certain that your monthly payments can cover living expenses. You'll want to get a rate quote for your immediate fixed annuity and calculate the monthly payouts.

Example: Sue has $300,000 that she plans to use for retirement over the next 10 years. She's found an immediate fixed annuity that offers 7% at a 10 year term. At 7%, Sue's money would nearly double in 10 years to $590,000. After taxes Sue would have approximately $500,000. $500,000 divided by 10 years, and divided again by 12 months, yields a monthly payment of $4,100. That's a comfortable income on which she can live, rain or shine. This immediate fixed annuity would be a safe investment because Sue is unlikely to withdrawal early.

Investing Too Young

Fixed annuities are poor investment choices for young individuals because of the 10% IRS tax penalty. Any withdrawal of income made prior to the age of 59.5 will incur a 10% penalty on top of regular taxes. Be sure to plan your annuity such that you're over 60 when it comes time to collect.

A fixed annuity should be thought of as a 401(k), which too imposes penalties for early withdrawal. Think of it not as a penalty but an incentive — the government wants to encourage you to save for retirement.

Don't Just Shop, Implement a Solid Retirement Strategy

Purchasing an annuity is a big decision. Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities.

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The Shorter-than-Expected Guarantee

A commonly overlooked aspect of many fixed annuities is the limited extent of their guaranteed rate. Read the contract carefully to determine how long the guaranteed rate actually lasts, because it can differ from the contract term.

For example, a fixed rate annuity might advertise itself as 6% fixed for 10 years, but if you ask the agent how long the guaranteed rate lasts, he might say, "the first 5 years". This is a common case, which means the rate could drop on year 6.

Although this limited guarantee can come as a surprise, it's not as bad as it sounds because most annuities feature a bail out provision. The bail out is a clause in the contract that allows you to cashout, penalty-free, if the guaranteed rate ever drops under 1% of the original. Meaning, should the rate drop from 6% to 4%, you can switch to another annuity free of charge.

Withdrawal Charges

Many annuities assess fees for early withdrawal beyond a specified yearly allowance. A typical withdrawal fee might start at 8% the first year and phase out to zero within 4 years. Such fees will adversely affect your returns, but on the up side, they're easy to avoid.

As long as you don't invest money needed to make ends meet, you won't be prone to early withdrawal. Statistics confirm that over 75% of annuity investors don't withdrawal early, avoiding the insurance company penalty altogether.

But let's supposed worse comes to worse and you have a rainy day. Even then you have a buffer in the form of a yearly withdraw allowance. This allowance ranges from 5-12%, letting you withdrawal $10,000 per year on a $100,000 investment penalty-free.

Comparing Apples to Apples: nearly all alternative long-term investments have penalties for early withdrawal — CDs, mutual funds, 401(k)s, IRAs, and even treasuries. That's because longer-maturing equities (loans and bonds) yield higher rates. It's also in the bank's or insurer's interest to hold your money as long as possible.

For example, a 1-year CD typically charges a 3-month interest penalty for early withdrawals. A 2-year CD charges a 6-month interest penalty. Even with T-Bills, interest is guaranteed only if they're held until the maturity date.

Interest-Only Penalty-Free Withdrawals:

Fixed annuities commonly feature a annual 10% free withdrawal allowance, which is a great feature, but some contracts limit this allowance to income earned. This means you CAN withdrawal up to 10% per year penalty-free, but only of income earned. Let's use an example to illustrate the point.

Example: John invests $100,000 in a fixed annuity at 6% for 10 years. His contract stipulates a 10% interest-only annual allowance. After the first year, John could only withdrawal $6,000 penalty-free, because that's how much income the annuity with generate in one year at 6%. If the annual allowance hadn't been interest-only, he could have withdrawn $10,000 penalty-free.

In practice, interest-only allowances aren't terribly confining. Notice that at the end of year two, John would have generated enough income to withdraw 10% penalty-free. As long as John doesn't plan to withdrawal 10% every year, he won't incur any penalties.

Worried about making an investment mistake? A licensed annuity specialist can answer any of your questions for free and provide a comprehensive quote comparision. Start Now.

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