06/01/15 - An Annuity In An IRA: Yes or No?

A previous column, Ten Stupid Things People Do to Mess Up Their IRA's, brought in some inquiries. Number 8 on the list of stupid things was "don't buy an annuity in your IRA." The IRA is already tax deferred, you don't need to buy a product for tax deferral -- the IRA already gives you a tax deferral.

Some e-mails were in support - such as the one which asked for permission to reprint the article in a client newsletter. Some disagreed with the statement that you shouldn't invest your IRA in a variable annuity. I stand by my guns. Keep variable annuities out of your IRA.

What is a variable annuity? A variable annuity is a contract with an insurance company that offers investment features that are similar in many respects to investments in mutual funds. A variable annuity has some features that are not available in mutual funds: tax-deferred treatment of earnings, a death benefit, and annuity payout options that can provide guaranteed income for life. On the down side, assets in the variable annuity do not get a step-up in basis when the owner dies and growth on the initial investment is eventually taxed at ordinary income rates, not capital gains rates.

Variable annuities have two phases: In the accumulation phase the investor pays premiums (or makes contributions) and these are allocated among various investments. In the distribution phase, the investor withdraws money, either as a lump sum or through various annuity payment options. The investment return inside the annuity varies with the mutual fund investments made inside the annuity - hence the name variable annuity. There is no guarantee that you will have earnings on your investment, and there is a risk that you will lose money.

Variable annuities are long-term investments. If you need to get your money out - you can expect to pay surrender charges for a specified period which can be as long as 7 years. (I have heard of contracts with 12 years of surrender charges.) A variable annuity that locks you in with surrender charges for 7 years typically pays the broker as much as 7% of your investment in an up-front commission. (Let me do the math for you: If you buy a $100,000 annuity the broker's commission could be $7,000.) There are annuities available now with no surrender charges - this is very important to know. Variable annuities without surrender charges may provide the selling broker with a commission as little as 1%. Most withdrawals before 59-1/2 are subject to a 10% penalty in addition to the income tax. Most variable annuities have sales charges. There are also mortality and expense risk charges, administrative fees, fund expenses for the mutual funds and additional charges for special features. Fees can be 2% or more of the annuities' value annually in addition to the surrender charge and sales charges.

Learn more next week.

Cheers!
Patti