Annuities in Your IRA – A warning sign

Your stockbroker, financial planner or investment advisor may suggest that you buy a variable annuity with the funds in your IRA account.  Your first thought should be – fire them.

Variable annuities have a place in the investment world, but it is generally not in your IRA or 401(k) account.

Annuities offer a variety of features, one of the most important of which is tax deferral.  Since investments in your IRA or 401(k) are already tax deferred much of the reason for purchasing an annuity may not be there.

Annuities frequently carry very high commission charges for the broker who sells the annuity to you.  And you can get lower cost investment accounts in your IRA without the annuity. So if your “financial professional” recommends an annuity for your IRA, watch out. 

The variety of features offered by variable annuity products can be confusing.  For this reason, it can be difficult for investors to understand what's being recommended for them to buy - especially when facing a hard-charging salesperson.

Before you consider purchasing a variable annuity, make sure you fully understand all of its terms. Carefully read the prospectus. Here are several factors you should bear in mind before investing:

1. Liquidity and Early Withdrawals

Deferred variable annuities are long-term investments. Getting out early can mean taking a loss. Many variable annuities assess surrender charges for withdrawals within a specified period, which can be as long as 6 to 8 years.

Also, any withdrawals before an investor reaches the age of 59 ½ are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.

2. Sales and Surrender Charges

Most variable annuities have a sales charge. Like Class B shares of mutual funds, many variable annuities shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example, a surrender charge could start at 7% in the first year and decline by 1% per year until it reaches zero.

3. Fees and Expenses

In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses when you invest in them, such as:

• Mortality and expense risk charges, which the insurance company charges for the insurance to cover:
• Guaranteed death benefits;
• Annuity payout options that can provide guaranteed income for life; or
• Guaranteed caps on administrative charges.
• Administrative fees, for record-keeping and other administrative expenses;
• Underlying fund expenses, relating to the investment sub-accounts; and
• Charges for special features, such as:
• Stepped-up death benefits;
• Guaranteed minimum income benefits;
• Long-term health insurance; or
• Principal protection.

These annual fees on variable annuities can reach 2% or more of the annuity's value. Remember, you will pay for each variable annuity benefit. If you don't need or want these features, you should consider whether this is an appropriate investment for you.

4. Taxes

While earnings in a variable annuity accrue on a tax-deferred basis - typically a big selling point - they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains, but allow your contributions to reduce your current taxable income. That's why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans.

Once you start withdrawing money from your variable annuity, earnings (but not principal) will be taxed at the ordinary income rate, rather than at the lower capital gains rates applied to investments in stocks, bonds, mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year.

Furthermore, proceeds of most variable annuities do not receive a "step-up" in cost basis when the owner dies. Other types of investments, such as stocks, bonds, and mutual funds, do provide a step up in tax basis upon the owner's death.

5. Bonus Credits

In an attempt to attract investors, many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity, generally ranging from 1% to 5% for each premium payment you make. Bonus credits, however, are usually not free. In order to fund them, insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods. 

6. Guarantees

Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company's financial strength.

7. Variable Annuities within IRAs

Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.

Also, if the annuity is within a traditional (rather than a Roth) IRA, the government requires that you start withdrawing income no later than the April 1 that follows your 70½ birthday, regardless of any surrender charges the annuity might impose.

All in all, when your financial advisor suggests annuities for your IRA, be very suspicious.