Fixed Annuities Disadvantages

As with any investment, fixed annuities have many advantages, but also some limitations when compared to other retirement products.  Here are the key disadvantages of fixed annuities:

  • Withdrawal Fees – If your fixed annuity is still within the surrender period, your annuity contract will typically state a maximum annual withdrawal limit.  If you withdraw more than that amount, you will be subject to penalty fees.  If you are no longer within the surrender period, then your fixed annuity will enable you to withdraw all money without any restrictions, penalties, or fees.
  • Early Withdrawal IRS Penalty – The IRS will charge you a 10% penalty tax if you withdraw your annuity investment before the age of 59.5.  However, an immediate annuity has an IRS exception to this rule.
  • Interest Income Not Taxed As Capital Gains – Compounded interest growth in an annuity is tax-differed, but once you begin receiving payments from an annuity, your interest income is taxed as ordinary income.  It is not taxed as a capital gain.

IRS Penalty

When you withdrawal money from an annuity prior to 59.5 years of age, the IRS will levy a 10% tax penalty on your withdrawn money.  The 10% penalty is in addition to the regular income tax rate you would pay on your interest income.  In most cases, this represents a large portion of your interest earnings in the annuity.  However, it is important to remember that the ordinary income tax rate and 10% penalty only applies to your interest earned in the annuity.  Your initial investment amount withdrawn from the annuity is not taxed.

There are occasions that the IRS penalty can be avoided:

  • Rolling over monies in one annuity to another annuity (1035 exchange)
  • Death of the annuitant
  • Certain cases of disability of the annuitant
  • Annuitization (withdrawing your initial deposit within one year of signing the annuity contract)

Understanding Taxes and Fixed Annuities

Fixed Annuities are a tax-deferred investment.  This means the interest you earn on your initial investment is allowed to compound and grow tax-free until you withdraw the money.  Eventually, you will have to pay taxes on the interest income.

This is why the investment is considered tax-deferred, and not tax-free.  When you do begin withdrawing from your annuity, your income will be taxed at your ordinary tax rate.

Since annuities are taxed at your ordinary tax rate, they have a tax disadvantage to other investments like stocks and mutual funds because those investments are taxed as capital gains.  In some instances, the capital gains tax of 15% could be substantially lower than your ordinary income tax rate.  However, there are instances when the higher tax rates on annuities are easily overcome by the advantages of an annuity:

  • Continued Tax Deferral – Taxes can be deferred even if one spouse dies.  If that spouse has the other named as a beneficiary, the annuity will pass to the other spouse tax-deferred.  It will continue to be tax deferred, until the surviving spouse withdraws the money.  In addition, the surviving spouse can pass the annuity on to his or her heirs and the monies can remain tax-deferred for up to 5 years.
  • Make Withdrawals at a Lower Tax Rate – Many retirees drop in tax bracket when they retire.  Because you can decide when to make your annuity withdrawals, you can choose to make your withdrawals during years when your tax bracket is lower.
  • Compounded Interest Grows Faster Tax-Deferred – When given a longer time frame (10-20 years), compounding interest that grows tax-deferred can grow much larger than interest that is taxed on an annual basis.  Investments that are taxed at the lower capital gains rate, but taxed annually, do not have the advantage of having all the interested earned for that year, compound year over year.
  • Roth IRA Option – Certain annuities can be designed as a Roth IRA.  In these instances, all withdrawals and payments remain tax-free.  To learn more about Roth IRA options within an annuity, please speak to your licensed annuity advisor.

Withdrawal Fees

Most annuity products feature a withdrawal fee for taking money out of the annuity before the annuity maturity date.  In most cases, the withdrawal fee will be reduced as time passes throughout the surrender period.  For example, a selected annuity may feature a 5 year surrender schedule that imposes a 5% fee in the first year, a 4% fee in the second year, and then 3%, and then 2%, and finally 1% in the 5th year.  Starting in the 6th year you could withdraw as much as you like without incurring a fee.

Be aware that although many annuities have a withdrawal fee, most still allow for a certain amount of annual withdrawals without incurring a fee.  Typically, this is a free withdrawal and is usually up to 10% after the first year.  This gives your annuity product a level of fee free liquidity.

The other common ways to avoid early withdrawal penalties are:

  • Death of the annuitant
  • Certain cases of disability of the annuitant
  •  Annuitization (withdrawing your initial deposit within one year of signing the annuity contract)

It is important to keep in mind that annuities are meant to be a longer-term investment.  The best way to avoid early withdrawal fees is to invest money that you do not need access to for the term of the annuity, or at least the early withdrawal fee term.

Deciding on the best annuity for your retirement need requires expert advice.  Click here to connect to a licensed annuity advisor in your area.