Annuities explained

The ~~Pros and~~ Cons of Annuities

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What you can do if you own an annuity now....

1) SWITCH TO VANGUARD IN A TAX FREE 1035 EXCHANGE - If the "surrender period" of your current annuity has expired then speak to your accountant about possibly switching to one of Vanguard's extremely low cost annuities through what's known in tax code as a tax-free "1035 exchange". Vanguard is VASTLY cheaper than the "retail annuity" that you were sold by your commission hungry "adviser". Vanguard's annuities have no insurance company "surrender periods", meaning if you want to get out at any time they impose no fees. Vanguard deals directly with the public and so this eliminates the "contingent deferred sales charge" that would otherwise be used to make sure you stay the course while paying high fees year after year to make up for your adviser's lavish commission. CLICK HERE to use Vanguard's cost calculator to see how much you will save in the first year by switching to Vanguard. It is critical that you speak to a tax adviser before proceeding.

If you are currently on a systemic withdrawal (SEPP) program, be absolutely certain to speak to a tax accountant to be sure that you follow the rules of a 1035 exchange. For example the money should be sent directly to the new insurance company, by direct deposit if possible. Be sure to restart (continue) the SEPP program in the same dollar amount and on the same day. Don't worry if either insurance company incorrectly declares that your SEPP program has been broken. They will likely code the prior year's withdrawal and / or future withdrawals as a "1" (early distribution). This error is actually "normal" because for liability reasons they don't want to underwrite it. Your accountant will likely tell you to simply change the coding to a "2" (early distribution with exception) on your tax return. I am told that filing a form 5329 is optional but recommended.

In deciding whether to do a 1035 exchange, whatever you do don't ask the non-fiduciary who sold you your current annuity (or the guy who is currently listed as your agent on your quarterly statements) because he will try to talk you out of switching in order to retain the 1/4% trailer fee that he earns year after year. Vanguard does not pay any commissions. Don't speak to yet another non-fiduciary "adviser" either as they will simply try to sell you yet another expensive commission based product. In order words don't make the same mistake twice!

2) CONSIDER STARTING A SYSTEMIC WITHDRAWAL PROGRAM - If you're under the age of 59 1/2, the insurance company surrender period has expired, and you're already invested in the lowest cost annuity that you want to stay in until age 59 1/2, then one thing that you can consider is taking advantage of is a systemic withdrawal program that allows you to begin taking money out of the annuity without incurring the 10% Federal tax penalty (or your state tax penalty). Then invest that withdrawn money in a normal portfolio of ETF's (like you should have done in the first place). Understand that since annuities are taxed at such a high rate ("ordinary income" rate) that at the time of distribution you will have to keep those distributions to a minimum in order to keep your taxes from getting out of control. This higher "ordinary income" tax rate one of the unavoidable and nasty downsides of annuities. However, at least a systemic withdrawal program offers a nice opportunity to minimize your ordinary income tax rate, especially if you are not generating a lot of income now. From my individual experience, under a systemic withdrawal program I was allowed to begin taking out approximately 5% per year. Your heirs will greatly appreciate it as well, since money from those gains will finally become stepped up. It is critical that you speak to your tax accountant.

3) CONSIDER GETTING PARTIALLY OR COMPLETELY OUT - Speak to a tax adviser who understands annuities and taxes. Be sure to make it clear that you have absolutely no interest in having them ever manage your money otherwise you might get biased advice. You want just a one time fiduciary consultation. If you are perhaps about age 40 or younger and think that either you might need some or all of your money before you turn age 59 1/2 and / or you just want to earn higher returns (after paying the pre-59 1/2 Federal and State surrender penalties) then surrendering some of all of your annuity now may or may not be a good move. If your annuity is no longer subject to the insurance company surrender penalties then you might want to consider admitting that you made a mistake and surrendering your original principal. You will still have to pay the mandatory 10% Federal tax penalty and State tax penalty (before age 59 1/2), and ordinary income taxes on any gains. The move might become a net gain after perhaps 20 years by instead being invested in low cost index ETF's.

Crunch the numbers using tax preparation software then get together with an accountant for their opinion. Be sure to compare hypothetical annual savings with the lowest cost annuity out there (that generally means Vanguard). Don't compare fees with your current annuity because a 1035 exchange is the other option that you will likely want to choose (if you don't get out completely). When comparing a portfolio of ETF's with a Vanguard annuity you will likely save about 0.7% per year because you would eliminate their 0.3% "mortality and expense" charge and the roughly 0.4% sub-fund management fee markup. Think of that 0.7% as pure savings that would be recouped each year. You should be able to make up for the state and federal tax penalties within 20 years. If you have gains, then yes they will also be taxed, but you will eventually have to pay those taxes anyway. Remember one of the purposes of getting out is to eliminate even more ordinary income taxes on future gains within the annuity. Again it is critical that you speak to a financial planner / tax accountant before you make this very bold move. Don't rely on this website for any kind personalized advice.

If the market ever takes a major hit like it did in 2008 then this might be a golden opportunity to consider pulling all or a lot of your money from your annuity at a "tax fire sale". At a market bottom like that of 2008, this would be the equivalent of getting out by paying 50% less in tax penalties compared to had you gotten out at the market peak of 2007.

If you are planning to withdraw a lot of annuity gains (not principal investment) then your taxes should be lower if you split up those withdrawals up into more than one tax year. Programs like TurboTax are very useful for creating hypothetical tax situations. For example withdrawing 25,000 in annuity gains might cost you 10% plus 14.5% in ordinary income taxes, whereas withdrawing $50,000 might cost you 10% plus 22.3% in ordinary income taxes. If the ordinary income taxes scare you then consider that you will eventually be paying ordinary income taxes on gains anyway.

Another tax consequence to consider is that once you turn age 59 1/2, are you going to want to start quickly liquidating your annuity in short order? If you liquidate large amounts quickly, your ordinary income tax rate could be very high, in which case it might make more sense to take smaller amounts out before your turn age 59 1/2. These are all complex questions that you must ask a tax adviser about.

4) CONSIDER TAKING THE MOST RISK OUTSIDE OF YOUR VARIABLE ANNUITY - If you have investments outside of a variable annuity then hopefully you view the big picture of both accounts to represent your entire portfolio. But do you diversify within the variable annuity and diversify within your separate account? Mindful of the fact that your annuity will be taxed to death at the ordinary income rate, a better approach might be to use the variable annuity for your conservative investments (such as bonds) and your separate account for aggressive investments (stocks) as much as possible. Over time your separate account should perform better than the annuity. This will save you in taxes and this will allow you to eventually withdraw money from your annuity faster since the annuity will have appreciated in value less. Remember annuity withdrawals must be tightly controlled (due to the higher annuity tax rate).

5) Eliminate any unnecessary "Cadillac Policy" extras that your broker may have added on such as unnecessary "death benefits" and riders. These add-ons boost your broker's commissions.

Beware of any adviser who suggests that you switch to yet another expensive "retail" annuity product

Brokers, insurance agents and other advisers earn huge commissions not just when they sell you an annuity, but when they get you to switch from one annuity to the next. They make lots of money off of transactions! Don't be surprised if at some point you get a phone call from Mr. Broker urging you to switch 100% of your annuity to what he says is a "better" annuity. If he is urging you to take an early withdrawal penalty (contingent deferred sales charge), then report him to the Securities and Exchange Commission (SEC). Even if you were talked into switching annuities at a penalty you should have up to 10 years to report that broker to the SEC.

In California, after years and years of fraud and abuse, it was finally written into law that the insurance company is now held accountable for making sure that an annuity sale or exchange is suitable to the investor. By law one thing that now signals a red flag is when an agent wants to process an annuity exchange or replacement within less than 5 years. But in other states that don't require the insurance company to scrutinize annuity transactions you may not be protected from a broker who wants to churn your account. Even in California the law doesn't go far enough. The "suitability standard" only protects you from blatantly unsuitable advice. There is no substitute for fiduciary advice. As previously stated, fiduciary advisers will virtually never sell annuities because they are inferior investments in so many ways.