Dear Liz: I’m a financial planner who liked your answer to the dad who wanted to fund his children’s IRAs but was shocked to see your recommendation (though with caveats) to purchase annuities.
I can’t imagine annuities would be suitable for children under any circumstances. Only under the best possible scenario of assumptions would an investment in an annuityâ€”even a low-cost annuityâ€”beat a reasonably tax-efficient mutual fund over any time period.
As long as money withdrawn from an annuity remains taxable as ordinary income, and as long as ordinary income tax rates are measurably higher than capital gains rates, this will be the case. I fear that brokers will be handing out your article as a tool to sell annuities for kids. To get an endorsement from someone of your reputation has probably helped some of them make this week’s sales goals. Let’s hope not!
Answer: Let’s hope not, indeed. Annuities tend to have high costs and do just one thing efficiently: turn capital gains that would otherwise qualify for low tax rates into ordinary income, which is taxed at a much higher rate.
Most investors would, as you point out, be much better off investing in index funds or other tax-efficient mutual funds.
However, annuities have one advantage that might appeal to this dad: They’re typically not counted in financial aid formulas, according to FinAid.org founder Mark Kantrowitz, because they’re considered retirement accounts. If the children don’t have enough earned income to fund IRAs, annuities would allow him to start saving for their retirements without having to worry about reducing their future aid packages.
This advantage may not outweigh all the disadvantages of annuities. But it’s something the dad should know about as he’s mulling over his options.