What do we think, say, and do with our money? Too often, we base our thoughts, phrase our words, and take action based on myths that have been passed down from parent to child, financial advisor to client, real estate agent to homebuyer, car salesman or insurance agent to consumer, from colleague to colleague, neighbor to neighbor, or friend to friend. The problem is that when financial reality hits--perhaps in our 40s, 50s, or even later--these financial myths explode, and make us wish that we had been paying closer attention to our own financial reality all along. 

Please read what I have to say. Things are going to be different in the century ahead from the way they were in the century that's now behind us. Most likely, you are not going to have a benevolent employer who will take care of you all your working life, then go on protecting you with a pension throughout your retirement. What will happen to Social Security, and the promise of that system, is anyone's guess--although the people who are guessing don't, for the most part, have high hopes that the system will protect you in the way you might hope it will. If you have an employer now, this employer is probably asking you to help fund your own retirement, or asking that you fund it yourself. If you are self-employed, as more and more of us are, you already know that you must fund your own retirement. Tomorrow, in other words, is becoming much more urgent for all of us. And for many of us, tomorrow may be closer than we think. 

You are going to be living longer in the next century, if you are statistically in alignment with most of us. So the question that presents itself is: how are you going to live tomorrow? And it is a question that we must all answer today. 


This is the great blanket investment to cover you when you're about to retire, or retired, right? Not so fast. Even though this is an investment that so many financial advisors just love to sell you, and lots of people just love to buy, more myths circle this investment than almost any other investment I know about. In some cases, annuities make sense, and in others they do not, but sooner or later someone will try to sell you these investments, so I want you to read this section very carefully. Getting into an investment is easy. Getting out is a different matter entirely. 

Grace's Story 

When my father died, everything was left to my mom in an insurance policy. He left her $56,000, which was pretty much all she had. We were just sort of figuring this all out, when my mom started feeling really unwell, and it turned out she had cancer. The doctors couldn't tell how long she had, but they knew it wasn't very long, a matter of months or maybe a little longer. So my brother, my mom, and I went to a financial advisor, who put her into an annuity with a 10 year certain period of time. He said this would give her the highest possible monthly income. Now we knew she wouldn't live for ten years, but we also wanted her to have as much money every month as she could get. The advisor was really persuasive, and what did we know, anyway? We said fine. 

My mom died just two months later, and of course she left the money to my brother and me, and again we had to sort everything out. We decided we didn't want the annuity anymore, and called the advisor again. This time he wasn't so persuasive. He said that if we cashed it in, we would only get $38,000. This was just two months later! Our so-called investment went down by 32 percent! We found out where some of that money went when my brother read the fine print more carefully. The advisor made a commission of $3000. But knowing that this was all she had, and knowing that she was ill, why would he put her into an investment that lost so much money? We still don't understand it. 

Grace is right not to understand it, for it makes no sense from her standpoint. From the broker's standpoint, however, it made a great deal of sense. Let's define what an annuity is, and how all the different ones work, and then I will explain when they make sense and when they do not. 

Different Kinds of Annuities

Today, for all practical purposes, there are five main kinds of annuities: a single premium deferred annuity, an immediate annuity, a variable annuity, an index annuity, and a tax-sheltered annuity. 

Where Do You Buy an Annuity? 

In the same way that a bank sells you an investment called a Certificate of Deposit, the United States Government sells you an investment called a Treasury Bill/Note/Bond, a city sells you an investment called a municipal bond, or a corporation sells you an investment known as a corporate bond, one of the investments that an insurance company can sell you is called an annuity. As with these other investments, you can buy an annuity through a brokerage firm or discount brokerage firm, and in some cases banks and mutual fund companies, the same is true for an annuity. 

Commissions / Fees 

The difference between the annuity and these other investments is that in most cases, annuities carry the highest commission percentage of them all, which is why brokers love them so. Usually the fee that the person "earns" by selling you an annuity is around 5% to 6%. In some cases, it can be higher and in others lower. 

What is an Annuity?  

An annuity (regardless of what kind of an annuity it is) is a contract (policy) between you as the policy holder and an insurance company. Depending on what kind of an annuity you have purchased, the insurance company will provide you with certain contractual guarantees. The minimum investment in an annuity is usually around $5000. 


The person who purchases the contract or the policy is known as the owner. This person can make any changes (to the beneficiary, to the amount of the distribution) they want any time they want-they own the policy. Two people or more can own a policy as well, as co-owners. If you want, you can also name a successor owner, someone you designate to step in as owner of the policy in the event of your death or, in some cases, an incapacity. 

Death Benefit / Annuitant 

In order for an annuity to qualify as a legitimate insurance contract--which is what allows it to enjoy certain tax advantages -- someone has to be insured. This person is known as the annuitant. The annuitant has no power whatsoever over the money, unless, as is often the case, the owner and the annuitant are the same person. There is no additional death benefit involved with an annuity, which makes it very different from other life insurance policies that you may be familiar with. The annuitant becomes important if one day you choose to annuitize your annuity, which means to get a monthly income for life, for the amount of income that you can receive will be determined by the annuitant's age. In other words, if I bought an annuity and named my mom the annuitant, she would qualify for much more money each month than I would, if I named myself the annuitant. This is because the monthly payments are partly based on the annuitant's life expectancy. The older they are the shorter their life expectancy, and the shorter the amount of time the insurance company will have to pay out those monthly payments. 

The Beneficiary

The beneficiary is the person or people to whom you, as owner, will leave all the money in the annuity when the annuitant dies. The owner decides how much to leave each beneficiary. The beneficiary and the annuitant cannot be the same person but the owner and the beneficiary can. For instance if I wanted to, I could own the policy have my mother be the annuitant and I could be the beneficiary. Usually, however, the way an annuity is set up the owner and the annuitant are the same person, and there is a different person who is the beneficiary. 

Non-Qualified / Qualified Annuities  

If you are buying an annuity with money that you have already paid taxes on, then you will be buying what's known as a non-qualified annuity. If you're buying an annuity with pretax money, then you will be buying what's known as a qualified annuity. Usually this happens when you buy an annuity within your IRA or retirement plan at work, or when you transfer your 401(k) or 403(b) retirement plans into an annuity. 

Deferral of Income Tax 

With the exception of an immediate annuity, all annuities defer income taxes owed on all of interest or gains that your original deposit has earned until the money is withdrawn by either you or your beneficiaries. In essence, they work for you as a tax shelter--a big draw of annuities. The true advantage of this is that your money is allowed to stay in the account earning interest or growing for you, rather than sitting in the coffers of the IRS. The taxes are deferred until you or your beneficiaries actually withdraw the money. If you're in a qualified annuity, you will owe ordinary income taxes on any and all of the money when you withdraw it, and if you are in a non-qualified annuity, you or your beneficiaries will owe ordinary income taxes only on the amount you withdraw above the amount you originally deposited. Non-qualified annuities are taxed on a LIFO method, which means last in, first out. So any interest or gains that your funds has earned are considered to have been put into your account last, and therefor this is the money that has to come out first. And you will owe taxes on these funds. Once you have withdrawn your earnings, then you can withdraw your original deposit without incurring any additional taxes. If you happen to die with money in an annuity, your beneficiaries will also have to pay taxes on any gains that you have not already paid taxes on when they withdraw those funds. 

Surrender Period 

Most annuities have what is known as a surrender period, or set amount of time during which you have to keep the majority of your money in the contract. Most surrender periods last from five to 10 years. Most contracts will allow you to take out at least 10% a year of the accumulated value of the account, even during the surrender period. If you take out more than that 10%, you will have to pay a surrender charge on the amount that you have withdrawn above that 10%. That surrender charge usually starts at around 7% and drops to zero by the time the surrender period is up. Let's say you are 60 years of age and put $50,000 into an non-qualified annuity, that is paying you 5%. At the end of the first year, your annuity is worth $52,500. You need $12,000. You can withdraw 10% of the $52,500, or $5240, without any penalty whatsoever. The additional $6760 you need will cost you approximately $500 in surrender charges. Please note that you will owe income tax on $2500. ($52,500 which is your accumulated value minus $50,000 which is your original deposit= $2500 taxable.)

Age Limitations 

In order to take advantage of the tax deferral the government does slap on a few restrictions, the primary one being that you have to be 59.5 in most cases to withdraw funds without a 10% penalty being imposed. 

A Single Premium Deferred Annuity (SPDA) 

One of the most popular annuities is the Single Premium Deferred Annuity. The SPDA got its name because people deposit a single premium, or lump sum, in the policy, and deferred because the taxes are postponed until money is withdrawn. An SPDA is a contract between you and an insurance company that guarantees you a specific interest rate for a specific period of time. The length of time the interest rate is guaranteed for can vary from one to seven years. In most cases the longer the guarantee, the lower the interest rate. This type of annuity is most easily compared to a certificate of deposit at a bank. In both cases, you get a guaranteed interest rate for a period of time. In an annuity you incur surrender charges if you take your money out, and in a CD you'll be faced with a six-month interest penalty if you withdraw money before the time period is up. The difference, however, is that with a certificate of deposit, you will be paying taxes each year on the interest you have earned, even if you don't withdraw it. With the SPDA, you will not. Here is the difference. Lets say you are 60 years of age, are in the 28% tax bracket and have $50,000 to invest. You do not need the interest off of this money to live nor expect to for many years to come if ever. But you want to know that this money is safe and sound. You could buy a CD or an annuity. Both investments are paying 5%, and the interest the money earns when it is paid out also earns 5%. Which one should you do? Assuming both investments paid you that 5% for the next 10 years, you would have a total of $81,445 with the annuity and only $71,214 with the CD. This is because you had to pay taxes yearly on the interest that the CD was earning even though you were not using it. In the annuity some of that tax money could earn interest for you as well. This comes into play later on when you might want to take the income. $81,445 generates $4,072 a year of income at 5% while $71,214 only generates $3560 a year. 

Who Might Want to Buy an SPDA? 

People who want to let their money grow risk free while averting income taxes, with the main goal being to use the investment to generate an income later on in life. 

Single Premium Immediate Annuity (SPIA) 

An immediate annuity is a contract with an insurance company that guarantees you an immediate fixed income for the rest of your life, and, in some cases, continuing for a certain period even after your death. For this promise, however, you must sign over all the money that you have deposited in the annuity to the insurance company with full knowledge that you will never be able to touch it again, apart from receiving the monthly income. There are also tax advantages to a policy like this, in that each monthly payment is considered a partial return of principal, so that a portion of your payments is not taxed. In addition to the interest rate your funds are earning, the return of some of your principal enables the company to give you what appears as a higher monthly income than you could probably get elsewhere on a guaranteed basis. 


The amount of income you will receive is based on your age, the current interest rates, and the maximum amount of time that you have chosen for the company to have pay out that stream of income, even if you were to die. The income options range from the highest monthly amounts of life only to lower amounts known as life plus five or ten years certain. Here's how they work.

  • If you were to choose life only, the company would pay you a certain amount of money every month starting immediately for the rest of your life. These fixed payments would continue like clockwork for as long as you are alive, even if you were to live another 100 years. You cannot outlive the income stream of an annuity no matter what option you choose. If, however, you opted for life only, and you died the month after you had started to receive this income, too bad--the payments stop and your beneficiaries get nothing. The reason that this option gives you the highest monthly income is that they know that once you die, they're off the hook, for it is for your life only. These monthly payments are based on your age and medical history as well as the current interest rate environment and an insurance company can usually call it pretty close as to how long you are projected to live. If they're wrong, and you die sooner than projected, they win big time. If you live your full life expectancy, then they're still perfectly happy, for they had already figured those numbers into your monthly payments. If they're wrong again, and you live far longer than expected, well, they figure that doesn't happen very often, so it's no big deal. 
  • The next option that you will get to choose from is life plus five or ten years certain. What this option means is that they will pay you or your beneficiaries your designated amount every month for as long as you live, but if you die, the annuity will pay your beneficiaries no less than for five or ten years (your choice) from the contract date. In other words, they pay for the duration of your life regardless of how long that may be, but no less than a period of five or ten years from the starting date, if you are not alive. If you were to die the month after you started receiving the monthly income, the company would have to keep paying your beneficiaries the same monthly amount for five or ten years, depending on which option you chose. Remember, once you have chosen an option and started your income, the amount is fixed for the rest of your life and or for the rest of the time your beneficiaries would receive the income as well. Even if interest rates skyrocket, your fixed income is just that, fixed. This annuity contract is one that can most easily be compared with a monthly pension from a corporation.

Who Might Want to Buy a SPIA

  • Those looking for a guaranteed monthly income with some tax benefits;
  • Those who have no beneficiaries to whom to leave their money;
  • Those who need right now a little higher income than just a straight interest bearing investment.
  • Those who want to take advantage of a high interest rate environment. The perfect time to have purchased an immediate annuity, for example, with respect to interest rates, would have been in the eighties, when interest rates were high, not in the late nineties, when interest rates are relatively low.


Please note that an SPIA is my least favorite of all investments. Purchasing an SPIA especially in today's low interest rate environment is not something that I would recommend doing. If interest rates go up, and as of the writing of this book I do not think they can go much further down, you are stuck at these low rates for the rest of your life. The process that we just described, receiving monthly income from an annuity, is known as annuitization, or annuitizing your annuity. What I want you to know is that you do not have to buy an immediate annuity in order to get monthly income from an annuity. You can do so by simply withdrawing money each and every month. This way you are not locked into an interest rate and can have access to your money as well as leave it to your beneficiaries. If for some reason you want to annuitize your annuity (and I cannot imagine why you would) what you need to know is that by definition, all annuities can be annuitized at any time, but please be careful, for some companies are better at facilitating the process than others. How much a company will give you monthly will depend on the actuarial factors and the interest rates that a company uses, so shop around if you ever plan to annuitize. 

Variable Annuity

With mutual funds gaining such ground in the recent past, receiving billions of investors' dollars, the insurance companies wanted to get into the act. So they created what they called a variable annuity. A variable annuity is also a contract with an insurance company for a specific period of time, but when you deposit money into a variable annuity, the money is used most often to purchase different mutual funds within the insurance contract. A variable annuity can have many funds for you to choose from, or just a few, depending on the company. The main draw of a variable annuity is that, as is the case with all annuities, you enjoy the so-called privilege of tax deferral. Even if you buy and sell a different mutual fund every day, you will not have to pay taxes on your gains until you actually withdraw funds from the annuity. This always appears to be a great benefit of the variable annuity, especially if you have large gains in a mutual fund not held in a variable annuity that you have wanted to sell, but haven't done so, because you'd have to pay so much in taxes. If you had invested in the same mutual fund within a variable annuity, you could sell it and, if you did not withdraw any money, still not pay any taxes until you did. Another so-called advantage is that in variable annuities, even if you invested 100% of your money in a risky mutual fund within the variable annuity, you are guaranteed that in the end you will never get back less than what you originally deposited or whatever the current value of the account is, whichever is more. In a regular mutual fund not held within a variable annuity, there is no such guarantee. 

Who Might Get Sold a Variable Annuity?

  • Someone who has no beneficiary to whom to leave their money;
  • Someone who likes to buy and sell mutual funds often;
  • Someone who is in a very high tax bracket now but plans to be in a much lower tax bracket when they retire.

Index Annuity 

In their struggle to keep up with mutual funds, around 1994 the insurance industry introduced another new kind of annuity, the Index Annuity. The reason for this new product was their desire to capture some money that was pouring into mutual funds that simply tracked the indexes, known as index funds, such as the Standard and Poor's 500 index. The Standard and Poor's 500 index is made up of 500 stocks that are actually more a gauge of what the entire stock market is doing than the traditional Dow Jones Industrial Average that we hear about every day. The reason this is true is that the Dow Jones Average is calculated from only 30 stocks, realistically not an overview. To participate in this index trend, the insurance companies created an index annuity. Even I have to admit that when this investment first came out that I liked the concept a lot--for the right investors. Today they are not as attractive as they once were but still worthy of knowing about.  

Here's how they work. Like all annuities, an index annuity is a contract with an insurance company for a specific period of time. The surrender period on an index annuity is usually about 7 to 10 years. The index annuity tracks an index such as the Standard and Poor's 500 index, and your return on your money will usually be a percentage of what that particular index did for your corresponding investment year. For instance, let's say your index annuity happens to track the S&P 500 index. If the S&P 500 index goes up, you would get a set percentage of what the yearly return of the index was from the time you deposited the money in this annuity until one year from that date, up to a pre-set maximum. In this case, let's say that your index annuity will give you 50% of what the S& P index returned, up to a maximum of 10%. You invest $20,000 on March 15th. March 15th one year later the S&P index has increased 30% since you opened the account. According to the terms of your annuity, they have to give you 50% of that increase up to a maximum of 10%. Since 50% of 30% is 15% which is 5% higher than the pre-set yearly maximum of 10% you will get credited with 10% of your original deposit or in this case $2,000. If the S&P index had only gone up 15% for the year, you would be entitled to 7.5% on your investment- (50% of 15%=7.5%). 

Why, you might be asking, do you only get a percentage of what the index does up to a maximum ? Why wouldn't it be better simply to invest in a mutual fund that buys the entire index and get 100% of the return? For some people, it would be better, but for others who do not want to take any risk at all this index annuity might be better. Here's why. When you invest in a regular index mutual fund, you get to participate 100% in all the upside--and any downward swerves as well. For instance, if the market went up 10% one year and the next year it went down 20%, you would participate in that downward movement as well. So lets say that you invested $20,000 in a good no load S&P index fund. The first year it went up 10%, now you would have $22,000. The next year it went down 20% now you would have only $17,600 or $2,400 under what you started with. That may make you too nervous. In many index annuities, you do not participate in any downside risk. To follow the same example, in a particular index annuity if you invested $20,000 and the market went up 10% you would end up with $21,000 for that year.(50% of 10% is 5% or $1,000) But the next year when the market went down 20%, you would not participate in that downside activity and you would still have $21,000 in your account. Within this particular index annuity, for example, your money can only go up; it cannot go down. In the long run I would rather have $21,000 after two years in my index annuity than just $17,600 in my S&P index fund. That is why the index annuity does not credit you with 100% of the return. It is set in reserve to protect you from the downside. Consider, too, one last safety feature. If you invest in an index annuity and the market goes down every single year, it still won't matter to you. Because it is an index annuity, the insurance company usually guarantees you that, after your surrender period is over, you will get at least 110% of what you originally put in. If you put in $20,000, the worst-cast scenario would leave you, after seven years, with $22,000, or about a 1.5% minimum guaranteed yearly return on your investment no matter what happens in the market.  

Bottom line: if you are willing to give up some upside potential, you can also protect yourself totally against downside risk with an index annuity 

Who Might Want to Buy an Index Annuity?  

Anyone who wants to invest in the market but is afraid of losing any money.

Tax Sheltered Annuity (TSA)

Last but not least is the TSA that many many school teachers and hospital workers are offered in their retirement plan. The TSA really falls more into the category of a retirement plan, for the money that is invested in a TSA is done so on a monthly basis, unlike most other annuities, where the money is deposited in a lump sum. Also with a TSA, all the money is qualified money, or money that has not yet had the taxes paid on it. For our purposes, the TSA is, in most cases, a fine investment. If you have a TSA in your retirement account, just make sure that the funds are performing in a such a way that you are happy with the results. 

Annuities: Myth and Reality 

Now that you know how annuities work, I want you also to know the ways in which they don't necessarily work well for investors. 

Myth: It is great to own annuities in my retirement accounts. 

Reality: What you need to know is that, even though there are exceptions holding an annuity within a retirement account is one concept that I have never agreed with. With the exception of the Roth IRA and Non Deductible IRA, all retirement plans--the traditional IRA; 401(k), 403(b), SEP-IRA, KEOGHs, SIMPLEs--are tax-sheltered vehicles funded with pre-tax dollars. In other words, you fund these plans with pre-tax dollars, and taxes on these funds, along with the growth of these funds, are deferred until the money is actually withdrawn. 

Annuities, remember, can be funded with pre-tax or post-tax dollars. So let's say that you have some money sitting in your money market account which you have already paid taxes on and you want to shelter it from current taxes. One way to do it would be to deposit your money into an annuity. Until you withdraw it, all your growth and interest is sheltered from taxes. In other words, an annuity offers you the same tax-deferring benefits as a retirement account does. So you tell me. What sense does it make to hold a tax-shelter vehicle like an annuity in an already tax-sheltered account like a retirement plan? Very little sense. 

Are there exceptions? Yes. Apart from a TSA, the only two reasons to purchase an annuity in a retirement plan are these.

Why One Would Purchase an Annuity in a Retirement Account

One, you are under the age of 59.5, and you need access to the funds in your retirement plan and you do not want to pay the 10% penalty. By purchasing an annuity, there is a way that you can get around that 10% penalty. (See The 9 Steps to Financial Freedom.) If this is the case, I highly recommend an annuity be purchased within a retirement account. 

Two, you are approaching retirement age and you want to invest in the market but are afraid of losing money. You are willing to take a smaller profit if you are guaranteed never to lose a penny. Since the index annuity accomplishes this goal, even if it is in your IRA, it can still make sense. 

Otherwise, let's examine why an annuity held in a retirement account isn't a sound investment. Let's use my old favorite the variable annuity as an example to start with. By definition, as we said before a variable annuity is nothing more than a bunch of mutual funds held by an insurance company, so that you can enjoy tax deferral on the growth of your money, whether it's held in a retirement account or not. For the privilege of having your taxes deferred the insurance company where your variable annuity is held is charging you many fees, as well as the potential surrender charge. These charges are in addition to the management fees and additional expenses that each mutual fund charges as well. In most cases, the fees for the insurance companies alone will amount to about 1.5% - 2% a year, right out of your pocket. Now, whether these make sense even outside a retirement account is something that you have to decide, but within a retirement account, if you ask me, this is way too hefty a price to pay for a privilege that is already inherent in your retirement account. Remember all retirement accounts are tax deferred regardless of what your money that is in the retirement account is invested in.  

Let's look at this a little more closely. Let's say that you have two IRAs, with $25,000 in each. One is invested in a variable annuity where you divided all your money equally among five mutual funds. The other $25,000 is in a IRA invested directly in the same five mutual funds, but not in a variable annuity. Let's say over the next 15 years the mutual funds averaged a total of 8.5% return. How much do you have in each IRA account after those 15 years? 

Investment Returns 

In the first one, invested with the variable annuity, you have $68,976, whereas, in the second one, invested directly into the mutual funds, you have $84,994. That is a $16,018 difference. Why? The variable annuity charges about 1.5% a year in fees that you did not have to pay in the mutual funds you invested with directly. There are no tax consequences to you, either, for all this money is in retirement accounts; the variable annuity, in other words, does not offer any additional tax advantages. What is more, a variable annuity has surrender charges, so even if you want to move your money out of the variable annuity altogether, you can't for a period of approximately 7 years. Long time to pay for a tax privilege that you already had.

State Premiun Tax 

Another consideration is that most annuities carry what is known as a state premium tax. This tax varies from state to state, but is levied on the amount you originally deposited into the annuity, and must be paid either when you surrender the annuity or if you annuitize the annuity. The tax can vary from .25% if the money was in a qualified plan such as an IRA, all the way up to 2.50% if it was in an annuity outside of a retirement plan. Unfortunately, this tax is seldom disclosed before one buys an annuity. In fact, most agents who sell annuities do not even know of its existence. But it exists, and in most cases it is another unnecessary fee that cuts into you overall return. 

Comparison Chart - Traditional IRA Verse a Variable Annuity Within an IRA

Below is a quick comparison showing you how a variable annuity on its own duplicates many of the advantages of an Ordinary IRA account.

tax deferral yes yes
pre- 59.5 tax penalty yes yes
70.5 mandatory withdrawal yes yes
surrender charges no yes (about 7 years)
state premium tax no yes
mortality charges no yes

This chart is not applicable to annuities held in ROTH IRAs  

Myth: With money you want to invest outside a retirement account, a variable annuity is a great way to invest in the market and not have to worry about taxes every time you buy or sell. 

Reality: It will not save you taxes in the long run. In theory, a variable annuity will save you taxes, but only in the short run, not over the long haul--which defeats the purpose for most people who buy annuities. With a variable annuity, it is true that every time you buy or sell a mutual fund within the annuity, you do not pay taxes. It is also true that if the mutual funds you are invested in through the variable annuity pay a distribution at the end of the year (known as a capital gains distribution), again you do not pay taxes on those distributions. However, this is where the advantages end, and the disadvantages begin. 

Ordinary Income Taxes  

In a variable annuity, you pay taxes when you withdraw your money. At what rate? You pay ordinary income taxes. Unlike a mutual fund where if you had held it for 12 months or more or you would only have to pay the capital gains rate and for some people, that rate could be quite low. By purchasing a variable annuity, you give up the right to pay capital gains tax rates as you opt for ordinary income tax rates instead. 

No Step Up in Basis 

Okay, you think, that's no big deal, for you plan to leave the money to your kids and never take it out of the annuity, so you will not have to worry about this tax problem. But with the variable annuity now you have passed this tax problem down to the kids, because when they take the money out of the variable annuity, they will also have to pay income taxes on any of the growth of your funds, never mind the additional fees and the state premium tax cutting into your return. If you had simply purchased good mutual funds not in a variable annuity, and never took the money out, when you die and leave those funds to your kids via your will or trust, they will receive what is called a step up in cost basis on the value of those funds based on their worth the day you died. If they then sold those funds after they inherited them, and before there was an upward price swing, they would not owe a penny in income taxes. 


You put $25,000 into a variable annuity, and by the time you die, your money has grown to $125,000. Your kids inherit the money, and they withdraw it, as most kids tend to do. They will owe income taxes on $100,000, along with any other fees. The difference between what you originally put in, $25,000, and what the money is now worth, $125,000, which is $100,000. 

Let's say you put that same $25,000 into some great stocks, tax-efficient mutual funds, and when you die, it is again worth $125,000. Your kids inherit the money, and they withdraw it in the same way. Here is the difference: when your kids inherit an investment such as mutual funds real estate or stocks from you (but not an annuity, a traditional IRA or retirement plan), they get what is called a step up in basis on this money, which simply means that their new cost basis in this investment is based on what it was worth the day you died. If it was worth $125,000 on that day then that is their new cost basis for tax purposes. Now if they turn around and sold this investment for $125,000, since their cost basis was $125,000 and they sold it for $125,000 there was no gain, and no gain means that they will not owe one penny in income taxes. 

Buying Tax Efficient Mutual Funds 

If end-of-year taxes are a concern, because you do not want to get hit with end of the year capital gains distribution from some of these mutual funds and that is why you are thinking about buying a variable annuity, think again. You could instead buy mutual funds that are tax efficient, which means that they do not make end-of-the-year capital gains distributions. You could also buy other investments that duplicate certain index mutual funds known as SPDRs (known as "spiders") that are sold on the American Stock exchange, where again, you won't run into end-of-the-year distributions. Or you could buy individual stocks and avoid the problem that way. 

Avoiding Taxes / Penalties

As for postponing taxes on your buying and selling of mutual funds, another reason you might be considering a variable annuity, the reality is that most people tend to hold on to their mutual funds, stocks, and so on for long period of time. Very few of us buy and sell very often. Most of us buy and hold, and buy more and hold. So for most of us, the tax implications are not so dire. If you do sell and you have held your investment for at least a year, the most you are going to pay is the capital gains tax rate, which is 20%. Not so bad. Remember however, when you take you money out of a variable annuity you are going to pay ordinary income taxes on the amount that you withdraw. But here is the bottom line, you will only owe taxes if you sell. You will not pay taxes if you do not sell the mutual fund (outside of possible end-of-year distributions). It is the same when someone owns a home. Maybe you purchased the home for $100,000 and now it is worth $300,000. You do not owe a penny in income tax if you do not sell that house no matter how much it appreciates; it works the same way with growth mutual funds. Thus if you are not, most likely, going to owe taxes for quite awhile, and when you do, it will probably be at the capital gains rate verses ordinary income for the variable annuity, then just what is the variable annuity sheltering you from? 


All for the desire not to pay taxes, which you very likely wouldn't have had to pay anyway, you lock up your money in a variable annuity where you cannot access it without surrender charges for a number of years--does this make sense to you? What is more, if you are under 59.5 and you need to take out all your money, you will pay a 10% penalty tax to the IRS. Also when you do close out the account for what ever reason most likely a State Premium Tax will be owed of about 2% of your original deposit. Does this make sense? No, it does not. 

Investment Return 

Remember our example, showing how a variable annuity works within an IRA, where the inside charges for fees and expenses can make a huge difference in your actual investment return? The same is true if you compare any variable annuity with a good mutual fund that is not held in a variable annuity. Myth: It is impossible to lose money in a variable annuity. Reality: That depends. Remember that an annuity shelters your money from immediate taxation, because it is considered an insurance product. For it to qualify as such, there has to be someone who is insured--the annuitant. Most variable annuities carry what is called a mortality fee, which usually runs you 1.3% a year or $3 for every $1000 that you invest. This mortality fee supposedly is to protect you against losing any of your money. You see the way an annuity works is that when the annuitant dies, the owner will get back at least the amount of the original deposit or the account value at the time of death, whichever is greater; this is what this fee covers. So in theory you do not get back less than you put in. However, in most cases the owner and the annuitant are the same person. This means that while you are alive if you need this money or want to take it out completely and close the account, and your balance at that time happens to be under what you originally deposited, guess what? You are out of luck and yes, you will have lost money. The only way you are guaranteed to get back at least 100% of what you deposited is when the annuitant dies. If you are the annuitant, a lot of good this guarantee--for which you have been paying dearly--will do you. It could, however, help you family out after you have gone. If you need to take out the money that is in the variable annuity at a time when you have less in there than what you deposited, what you could do is that if you do not close the account completely, and leave a little money in there, if you are the annuitant when you die, your beneficiaries will at least get the amount that would have brought you back to even. 


You deposit $25,000 into a variable annuity. You are the owner and the annuitant. Sometime later, you need this money. When you go to cash it out, the account is only worth $19,000. You take out $18,000, leaving $1000 in the annuity. Years later, you die. Your beneficiaries will get $7000. Remember, you have been paying that mortality fee of 1.3% a year to guarantee that on your death your beneficiaries get back 100% of your original deposit, or whatever the account is currently worth, whichever one is higher. In this case, your original deposit of $25,000 is higher. So since you withdrew $18,000, the insurance company now on your death owes your beneficiaries that additional $7000. ($25,000 -$18,000 =$7000) Did this help you while you were alive? No. Did you get to take the loss off your taxes, or use it to offset a gain? No. And what if you hadn't died in just a few years? How long did that extra money have to sit in the account, possibly not doing so well? Perhaps for a long, long time. Even as the extra charges and fees continued to accrue. Do I personally think that extra mortality charge to protect what you have is worth it? No, I do not. 

Undoing the Possible Damage 

If you already have many variable annuities and decide now that this isn't what you want, now what do you do? 

Well, this will depend. If--with the exception of the TSA or other exceptions noted above--they are in your retirement account, as soon as the surrender charges are no longer being imposed, I most likely would say to sell them and invest instead into some solid, well rated no-load mutual funds. Since the money is already sheltered within a retirement plan, you will not have to worry about tax implications. It is entirely probable that you can buy the same funds that you are currently invested in with the variable annuity. Discount brokerage firms like Charles Schwab offer many mutual funds for you to choose from, so you could probably duplicate what you had in your annuity if you want without much difficulty at all. Remember the fees that the mutual funds charge for managing the account are most likely the same whether you are in or outside of a variable annuity. It is the fees from the insurance company that you will be getting rid of--and rightfully so. 

If you are invested in a variable annuity outside of your retirement plan, getting out can be more complicated. You may still want to wait for the surrender period to be up. But there are other rules that govern an annuity, such as penalties for withdrawals prior to the age of 59.5, taxation on the money when withdrawn, as well as the state premium tax if you were to surrender the account altogether. Because all these rules--which is one of the main reasons why I do not like variable annuities to begin with--have to be taken into consideration, I would advise you please to see a professional who has nothing to gain from giving you honest advice so that you can give them the exact specifics of your situation. Everything from your age, the terms of the annuity you purchased, your tax bracket, how long you have owned it, your financial goals and so on will determine the actions if any that should be taken with your particular contract. Just make sure that before you buy another one, it really is the best thing for you to do. 

Annuities: When to Say Yes

Is there ever a time where an annuity does make sense? Yes. We have seen how TSAs make sense, and sometimes index annuities, but there is also one other circumstance. If your goal is to have income during retirement years, you do not want to take any risk with this money, you want to avoid paying taxes now, but you are still not currently in a high enough tax bracket to make municipal bonds make sense, and lastly feel that you will be in an even lower tax bracket when you retire, then I do have to say that a single premium deferred annuity is great. 


You deposit $25,000 into a SPDA, and over the next 15 years it pays you an average of 5% on your money. Tax deferred, your money will grow to $51,973. Now you need income. Simply start taking the interest from the $51,973. If the interest rate you are offered is 6%, there would be a total of $3118 a year on which you would owe taxes. If instead you had kept that money in a bank's certificate of deposit, and let's say you were in the 15% tax bracket, over the same 15 years, you would only have accumulated $46,675. The income on that 6% interest would only be $2800 on which you would owe taxes. If you put your money in an SPDA, and it performed as it did in our example, this would mean $318 a year difference in income to you. Remember, every penny counts, especially during your retirement years. When you take into account how much money you really did invest and the real rate of return your money earned over the long haul, the difference could be a significant amount. 

Bottom Line on Annuities 

As you have seen, there is much to know about this one investment category that so often is presented to us as a given, as if we would never want to look deeper into where our money could go instead. In the end, however, not very many of us should be investing in annuities at all. Yes, as we've seen, there are reasons why they sometimes make sense, but there are even more reasons why they mostly do not. Please be careful, as for the most part even though this is not an investment that will devastate you, this is also not an investment in most cases (SPDAs excluded) that will give you the biggest bang for your buck. When in doubt, get a second or a third opinion. Make sure the people you are getting the second or third opinion from know from the outset that they will not be selling you anything, that you just are asking for advice. Take any sales motivation out of the transaction. And look to and beyond your money to see whether you can do better.

A.M. Best
(908) 439-2200

Duff & Phelps 
(312) 263-2610 

(212) 553-0300 

Standard & Poor's
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