Let me start by saying that very few people should ever have an annuity. If someone has sold you an annuity, I am not saying you should sell it immediately and get out but be cautious. If you do not know, an annuity is a product that creates an umbrella. You then put things in under this umbrella and the IRS cannot get to it. If it was supposed to be taxed, then under an annuity it will not be taxed while it is growing. This is the way annuities are sold and since most people are more focused on what things cost than what they can make, most people think this is a great deal.
There are two main types of annuities – fixed annuities and variable annuities. I never suggest anyone should get a fixed annuity. This is a product that guarantees you 5% or so a year. This is because your assets are commingled with the insurance company’s assets. If the insurance company files bankruptcy, you lose your money. This is why an annuity is tax-deferred. In other words Congress said, “you can have the annuity tax-deferred but your money is then commingled with the insurance company’s assets so if they get sued, attorneys can place a lien against your annuity.
A variable annuity is invested in ownership. This is the type of annuity to own if you absolutely have to have one. Your money will not be exposed to creditors of the insurance company because the money is not with insurance company – it is invested in something. Let us say you have a variable annuity – never put retirement money into a variable annuity. A variable annuity creates an umbrella that protects the things under it so why would you put an IRA into a variable annuity. An IRA by definition is tax-deferred. Why would you pay an insurance company an extra 2% a year to act as a middle man to get your IRA tax-deferred. The IRA already is tax-deferred. Why would you put a 401(k) in there? A 403(b)? Why would you place a municipal bond in there? You are stunting the growth of your investment by having the insurance company create this umbrella.
But let us look at the other side. What if you put money that is not tax-deferred into a variable annuity? Therefore, if you had it, the investment would be taxed but if you placed it in a variable annuity it would not be taxed. Now this sounds reasonable right? Let us take a closer look and see.
Suppose you have $100,000 and we put it in mutual fund X. Then you take another $100,000 and put it in a variable annuity with mutual fund X. The insurance salesperson would tell you that you are better off with the variable annuity because it grows tax-deferred rather than the mutual fund which you will have to pay taxes on as it grows. That is a true statement but you are not getting the whole story. Let us analyze this a little closer. Remember that I am using the same two investments in this example so both will have the same level of growth. The only difference is that one is in an annuity which is tax-deferred and the other is in the mutual fund which will be taxed. Say that because I am such a great investor for you, I doubled your money in both of these investments in a week. I call you up to tell you that your money doubled to $200,000 in each investment so you have a heart attack and die. Your spouse mourns for a few minutes and then asks me how much these are worth. I tell the spouse that they are both now worth $225,000. The spouse tells me that they wish to sell one so that they can build a new house.
Which one should I sell?
If I sell the variable annuity, the spouse is going to pay taxes from dollar one of the investment to what it is worth when they sell it - at income tax rates. For this example let us say it is 28% federal and 7% state – that is 35% of the $125,000 gain! If the spouse sells the mutual fund, the spouse is taxed from time of death which in this case would be $25,000 – at capital gains rates. Ok, so which do you want?
Keep this number in your mind - $80,000. In 2005, if you make under $80,000 and sell the mutual fund, your capital gains rate is 5%. If you make over $80,000, your capital gains rate is 15% on this $25,000. Your income tax rates are the same. Now remember this – starting in January 2009, if you make under $80,000 a year, your capital gains rate is zero! So what an insurance company salesperson is doing to people who make under $80,000 is putting them into an annuity that they are not going to sell until after 2009 which they will then have to pay income tax rates on instead of something that if they sell after January 2009 is tax free.
Do the sales people tell you this? No, they tell you that you can get this tax free growth. Big deal – if you pull it out you pay income tax rates. In the mutual fund, you pay nothing if sold after January 2009 when this law takes effect. Now, if you make over $80,000 you have to pay 15% on the mutual fund. Would you rather pay 15% or 35%? This is why I tell people to be cautious with annuities. We also find that the average fee for the annuity is 2% but you do not have to pay taxes while the annuity is growing. So what the insurance company is dong is diverting the money going to the government and placing it into their pockets yet at the end of the deal you still have to pay income tax rates. People are never shown this which is why I could never recommend that people place money into an annuity.
A big word of caution – if you currently own an annuity of any kind, do not cash it in just because I bad mouth them. It may cost you too much in taxes and penalties to get out of it so you need to get with an expert to help make the best of a bad situation.
Roland R. Manarin is president and founder of Lifetime Achievement Fund, Inc. and Manarin Investment Counsel, Ltd. For decades Manarin has been educating the public about investing and financial planning through this wealth-building seminar series and as co-host of the regional radio program "Its Your Money." Through the Manarin family of companies, Roland Manarin oversees in excess of $350 million in assets.
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