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Annuities

Q&A: Annuities can come with a tax surprise

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Dear Liz: I made a one-time purchase of a variable deferred annuity with a $10,000 inheritance I received about 25 years ago, based on a co-worker’s advice. Over the years I have not made any additional payments or withdrawn any funds. It matures in about a year with an option of withdrawing the lump sum, which was nearly $60,000 this year, or receiving monthly payments. Would I be subject to capital gains taxes for the entire $50,000 increase if I take the lump sum? Are there any special tax exemptions or rules I should be aware of?

Answer: The increase in your annuity’s value isn’t subject to capital gains taxes. Instead, the gain will be subject to higher — perhaps much higher — income tax rates, regardless of whether you choose the lump sum or monthly payments.

Variable annuities are insurance products that allow you to invest money tax-deferred for retirement. Like other retirement accounts, you could face penalties for early withdrawal in addition to income taxes if you take money out before you’re 59½.

Taking the lump sum could push you into a higher tax bracket and possibly cause a temporary increase in your Medicare premiums if you’re 65 or older. If you opt for monthly payments instead, you’re likely giving up access to the money in an emergency. (Annuitization means you’re giving up the lump sum you could have accepted in exchange for a stream of monthly payments that typically lasts for life.)

A tax pro can help you weigh the effects of the different withdrawal options on your finances.

Q&A: Lump sum vs. annuity

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Dear Liz: You recently answered a question about taking a lump sum retirement versus an ongoing pension. You didn’t mention that the pension will stop when the employee dies (whether it’s after 40 years or 40 days) or when the spouse dies (same thing) if that was chosen. The children get nothing. What about taking the lump sum and putting it in a fixed indexed annuity? Yes, there is a yearly fee, but then the money can continue to the spouse, children and on and on and on.

Answer: See above. There’s more than a single “yearly fee” with these annuities, which are complicated insurance products that tend to have high costs and pay high commissions to the advisors who recommend them. If you’re considering this investment, you should run it past a fee-only financial planner first.

Many people dislike the idea that an annuity stops when they do, which is why insurers are often willing to sell you — for an additional fee — a guarantee that something will be leftover. There may be better, less expensive ways to leave a legacy, which a fee-only planner can discuss with you.

Q&A: Annuities have indirect costs

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Dear Liz: Thank for your right-on reply to the reader who claimed that fixed and indexed annuities were available at no cost to investors. I am so tired of hearing from agents and investors that their annuity is great and does not have fees!

Answer: Insurance companies aren’t charities providing investments at no cost. They’re businesses that have to keep the lights on and pay the people who sell their products. With fixed and indexed annuities, the cost is built into the interest rate spread, which is the difference between what the insurer earns on your money and what it pays into your account. The investor pays an indirect cost, rather than a direct cost that’s explicitly disclosed.

Q&A: Retirement annuity vs lump sum

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Dear Liz: I am 54 and considering retiring in three or four years. I have been fortunate to work at a Fortune 100 company for 30-plus years and have both a defined benefit pension plan and a 401(k). When I retire, we have the option of taking a lump sum or an annuity. Most financial people I talk to strongly recommend taking the lump sum, though I wonder if it is not just so there is more money to manage? My current inclination is to take the annuity (with survivor benefit for my wife). I think we can live off the annuity alone and use the 401(k) for emergency/fun/help-the-kids money, etc. I think if I took the lump sum and invested it, I’d always worry about what the market was doing. Am I off base?

Answer: Not at all.

Theoretically, you often can make more money by taking a lump sum and investing it than by accepting the annuity, which offers a lifetime stream of payments. But perhaps you’ve heard the quote “In theory, theory and practice are the same; in practice, they are not.” Anyone who knows much about behavioral finance knows there are many, many ways such a plan can go wrong.

You could pick the wrong investments, take too much or too little risk, trade too much or spend too much, and wind up much worse off than if you’d chosen the annuity. You could turn over the investing decisions to a pro, but there’s no guarantee that person won’t make mistakes. Even if he or she chooses great investments and allocates your assets well, your nest egg could still take a hit from the market.

If you were comfortable taking that extra risk to get the extra possible reward of more cash, accepting the lump sum would be the way to go. Since you’re not, there’s nothing wrong with taking the annuity. Opting for a survivor’s benefit means your wife will have guaranteed income should you die first.

Before you pull the plug at work, though, make sure you talk to a fee-only planner who charges by the hour to make sure your retirement plan makes sense. (Planners paid by the hour won’t have a vested interest in how you opt to manage your retirement funds.) Your assets probably will have to last 30 or 40 years, and you’ll have to figure out how to pay for the ever-escalating cost of health insurance. This can be a tricky process, so you’ll want expert, unconflicted help.

Get second opinion before buying cash-value insurance

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Dear Liz: I think you missed one of the possibilities when a reader wrote to you about a pitch he received from an insurance salesman. The salesman wanted the reader to stop funding his 401(k) and instead invest in a contract that would guarantee his principal but cap his returns in any given year. You thought the salesman was pitching an equity indexed annuity, but it’s possible he was promoting an indexed universal life policy, which would offer the same guarantees of principal and offer tax-free loans.

Answer: You may be correct — in which case the product being pitched is just as unlikely to be a good fit for the 61-year-old reader as an equity indexed annuity.

Cash-value life insurance policies typically have high expenses and make sense only when there’s a permanent need for life insurance. If the reader doesn’t have people who are financially dependent on him, he may not need life insurance at all.

Furthermore, the “lapse rate” for cash-value life insurance policies tends to be high, which means many people stop paying the costly premiums long before they accumulate any cash value that can be tapped.

Before you invest in any annuity or life insurance product, get an independent second opinion. One way is to run the product past a fee-only financial planner, who should be able to analyze the product and advise you of options that may be a better fit for your situation. If you just want a detailed analysis of the policy itself, you can pay $100 to EvaluateLifeInsurance.org, which is run by former state insurance commissioner James Hunt.

Should you take a lump sum now or an annuity check later?

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Dear Liz: My former employer is offering the one-time opportunity to receive the value of my pension benefit as a lump-sum payment. The other option is to leave the money where it is and get a guaranteed monthly check from a single life annuity when I reach retirement age. I am 40 and single, and I have been investing regularly in a 401(k) since graduating from college. I have minimal debt aside from a car payment. When does it make financial sense to take a lump sum now instead of an annuity check later?

Answer: Theoretically, you often could do better taking a lump sum and investing it rather than waiting for a payoff in retirement. That assumes that you invest wisely, that the markets cooperate, that you don’t pay too much in investing expenses and that you don’t do anything foolish, like raid the funds early.

That’s assuming a lot. Another factor to consider is that the annuity is designed to continue until you die. It’s a kind of “longevity insurance” that can help you pay your bills if you live a long life.

Some financial advisors will encourage you to take the lump sum, since they may be paid more if you invest it with them. Consider consulting instead a fee-only financial planner who charges by the hour — in other words, someone who doesn’t have a dog in this particular fight. The planner can walk you through the math of comparing a lump sum to a later annuity and help you understand the consequences of both paths. This is a big enough decision that it’s worth paying a few hundred bucks to get some expert advice.