Annuities are attractive to many who are looking to create a secure retirement plan. The reasons are clear: annuities can provide a guaranteed income for life, and income earned on annuities is tax deferred. Additionally, because many annuity products allow you to select from a variety of mutual fund subaccounts, you can often change your investment direction within an annuity at little or no cost.
As with all financial products, however, it’s important to weigh the pros and cons of annuity investment. While annuities can provide tremendous benefits for some investors, the costs involved can be tricky to fully understand. If you own an annuity or are considering purchasing one, be sure to look closely at its real costs.
Depending on the type of annuity you purchase, it can come with a number of different fees— some of which can be difficult to ascertain. Be sure you understand whether and how much your annuity is costing you in the following fees.
What commission is earned on the sale of your annuity? Commission rates can vary widely, from as little as 1% to as high as 10%. Generally speaking, more complex annuity products come with higher commissions than simpler products. If your agent claims there is no commission, this is most likely misleading and really means that the commission is built into the policy so you don’t see it as a separate line item charge. Even if you don’t see the cost of the commission coming out of your investment, you should understand that a higher commission generally means that you will also be subject to surrender fees for a longer period of time.
If you purchase a deferred annuity, it will be subject to surrender fees that apply in the event that you withdraw the money early. Depending on the commission associated with the annuity sale, the surrender period may be as little as two years or more than ten years.
This is a basic fee to cover the costs of providing and communicating about the annuity. It is typical for administrative fees to be 0.1–0.3% of the policy value annually.
Mortality & Expense Risk Charge (M&E)
The M&E charge is intended to cover the cost of providing an annuity’s death benefits and other income guarantees. A typical range for this fee is 0.5–1.5% per year with an average of 1.25%.
Variable annuities come with fees for the management of investment sub-accounts held within the annuity. It’s common for investment fees to range between 0.25–2% of the value of the annuity’s sub-accounts annually.
These fees are associated with additional income or death benefits you may choose. For example, you might purchase a rider that allows you to collect an annual income from the annuity at a younger age or that guarantees that the insurance company will pay your heirs the difference in the event that you die before your premium payments have been returned to you in the form of income. Riders might cost 0.25%–1% of the value of your annuity per year.
Related Article: What Is the Best Age to Start Saving for Retirement?
Early Withdrawal Penalty
In addition to potentially being subject to surrender fees, withdrawing funds from your annuity early can leave you with a shocking tax bill. Because it is a tax-deferred retirement account, the U.S. government levies a hefty 10% penalty on earnings withdrawn before you reach age 59 ½.
Earnings Taxed as Regular Income
While contributions to your annuity are taxed before deposit (and therefore not subject to tax upon withdrawal), earnings on an annuity are subject to ordinary income tax, which can be much higher than capital gains tax. For this reason, some investors are better served by investing in stocks and other products that are subject to capital gains rather than income tax.
While the specified guaranteed income for life that some annuities offer may seem like they would provide security for your elder years, it’s vital to remember that a dollar is never what it used to be. Over the past ten years, inflation in the U.S. has averaged 1.8% per year, and over the past 30 years, it’s averaged 2.5% annually. That means that what seems like a comfortable retirement income today will almost certainly become less so over time. For example, a $5,000 monthly income, subject to a 2% annual rate of inflation, would be worth only $3,406 20 years from now; at 3% inflation, it would be worth just $2,803. If you decide to use an annuity as part of your retirement plan, make sure you plan ahead for this kind of decrease in buying power.
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Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice.