Let’s continue our discussion of annuities. We noted in our earlier post that some investment managers and advisors – including a certain firm based in Camas, Washington – are not particularly fond of annuities. We suggested it might make sense to look at annuities with a fresh perspective. We reviewed what an annuity is, how to fund the purchase of one, and we considered annuitization options.

There are various ways to invest the funds held inside an annuity. In the case of an immediate annuity, the insurance company is contractually bound to pay the stream of annuity payments, and it assumes all the investment risk to back that guarantee. This is called a fixed, immediate annuity.

Variable annuities, in contrast, allow you to choose from a menu of investment “sub-accounts” that look and act very much like traditional mutual funds. Index annuities tie the investment results of the annuity (prior to annuitization) to the performance of an index, such as the Standard & Poor’s 500 index.

An attractive feature of annuities is that the growth in the annuity over time is not subject to income tax. So, when you own an annuity (purchased through a lump sum or a series of payments), the investment growth inside the annuity will not be taxed until money is withdrawn.

When money is withdrawn, the tax treatment varies based on how it is taken. If you take your money out of an annuity without annuitizing it, the payments are considered taxable income (not capital gains) until all earnings have been received. Then, future withdrawals are considered a return of basis (i.e. the original investment) and are received free of income tax. Note that we are ignoring the case of an annuity owned inside an IRA.

If you “annuitize” your annuity, then the payments you receive are considered a return of both principal (i.e. your original investment in the contract) and earnings. The amount of principal in each payment is calculated by dividing the total original investment in the contract by your life expectancy. That principal amount of each payment is received tax-free, and the remainder is considered income and is subject to income tax.

Here’s a simple example:
You’re a 62-year-old woman, and you’re considering investing $100,000 in an immediate annuity. A quick online quote indicates that you can expect to receive $494 per month for the rest of your life. Your life expectancy, according to the Social Security Administration website, is exactly 20 years. So, we can calculate that if you live to age 82, you’ll receive a total of $118,560 in payments ($494, times 240 months). We know that $417 of each payment will represent a return of your original investment ($100,000 investment, divided by 240 months). Thus, the difference, $77 ($494 minus $417), will be taxed as ordinary income.

Now, back to the criticisms coming out of Camas. It’s true that many annuities are very expensive. We have analyzed some annuity products and found that the total cost of annual ownership for some are in excess of 3%. It is simply foolish for anyone to own a product that costs this much, particularly in the accumulation phase (i.e. before you annuitize the contract into a stream of payments). A low-cost portfolio managed by a professional investment advisor typically costs no more than 1.25-1.50%, including the cost of the underlying investments. The potential tax benefits from the annuity are unlikely to be worth an additional 1.50% or more. Also, many annuities are so complicated that few investors (or the agents selling them, for that matter) understand them. If you don’t understand how an investment works, don’t buy it.

So, in summary, we like some annuities. They can provide guaranteed lifetime income and they have attractive tax features. Please contact us if you would like to discuss annuities further and how they might play a role in your retirement plan.

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