Annuities do you really understand what you're getting for your money?

Many investors are confused by annuities and question whether or not they should own them. By Michael Matty, CFA, CFP, Chief Investment Officer, St. Germain Investment Management Special to PRIME For most investors, annuities just don't make much sense, financially or logically. They don't make sense financially as the tax deferral (one of the few benefits to an annuity) is not as great a benefit as often perceived. And they don't make sense logically, as most annuities are so complex that the annuity holder would be hard pressed to explain exactly what it is they own. In fact, they may well have been sold the annuity by a salesperson, who may not have fully understood the product themselves. And because annuities pay one of the highest commissions available on financial products, many salespersons' incentives may be contrary to yours. What exactly is an annuity? An annuity offers you the opportunity to set aside money today, have the assets grow tax deferred, and then withdraw your assets based on different options (lifetime income, fixed period income, etc.) There are three basic types of underlying investments within the annuities: fixed annuities, variable annuities, and the latest variant, equity index annuities. The IRA annuity mistake Tax deferred growth? So what's not to like about annuities? In general, a number of items. First, many investors make the mistake of purchasing annuities within their IRA. This typically makes no sense, as your IRA is already tax deferred. One of the potential advantages (among numerous disadvantages) of annuities is this tax deferral. But by purchasing an annuity within your IRA, you do not achieve any additional tax advantage. You do incur high surrender charges lasting seven years (or more), high annual expenses (mortality/expense charges and management fees can typically approach 2-3% per year), and limitations on investment choices. The tax deferral penalty So an annuity within an IRA is usually a very poor choice. But what about for your after-tax dollars? You will still incur the high surrender charges, high annual expenses and limits upon your investment choices, as well as penalties for withdrawals prior to age 59 1/2, but you do get some tax deferral. How valuable is this? In most cases, the higher fees eat up any tax advantage. But even if your annuity return turns out to be greater due to this tax-deferral, it shocks many people to discover that there is a significantly different tax treatment for annuity withdrawals. This is because the IRS has granted annuities a tax deferred status, but the trade off is this penalty treatment of distributions. Under the IRS rules: 1) Annuity distributions are taxed as regular income, not at the preferential capital gains rates (this means a tax bill that may be twice as high) 2) Any distributions (if not annuitized) are automatically treated as distributions of gains, and therefore are fully taxable 3) If you pass away with an annuity within your estate, there is no step-up in cost basis. This can result in considerably higher taxes for your heirs. Buy an annuity if ... So who might an annuity be appropriate for? If you have maxed out your 401k and/or IRA contributions, you expect to be in a significantly lower tax bracket in retirement, are assured that you will not need the money prior to age 59 1/2, have a very long time horizon before needing the assets (in order to take advantage of the tax deferral), don't mind the limitations on investment choices, you are unconcerned about the potential estate tax issues and may want to annuitize the payouts in retirement, an annuity may be worth the additional expense and limitations. But think carefully first For most investors, however, seeking out tax efficient investment choices (either mutual funds or separate account management) that provide great tax advantages at a much lower cost will be far more advantageous than an annuity. You can maintain a high degree of flexibility, avoid some potentially onerous tax consequences, and perhaps most importantly, own something that you understand. Annuities may be a good move for you...just make sure you know what you are buying. And don't stop asking questions until you understand it. After all, if you don't understand an investment, how can you be sure that it's in your best interest? Column provided to PRIME by: St. Germain Investment Management; 1500 Main Street; Springfield, MA 01115 Phone is 413-733-5111 or 800-443-7624 www.djstgermain.com.