Buying an Annuity? Avoid These Three Classic Mistakes

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published 5 December 2024

Building a stable nest egg with a diversified mix of asset classes is the ultimate goal when planning for retirement. There are various strategies and products you can invest in to help establish, and potentially increase, your income in retirement. A common one is to purchase an annuity. Annuities have the potential to provide a steady stream of income, but if you don’t shop carefully, you could risk losing your investment altogether.

Before purchasing an annuity, it’s important to understand how these products work. Annuities are contracts issued and distributed by an insurance provider. They have two different phases: The accumulation phase and the annuitization phase. During the accumulation phase, the investor funds the annuity either with monthly payments or a lump sum. The money then grows depending on the type of annuity it is. During the annuitization, or payout phase, the investor receives that money for a fixed time or the remainder of their life. These products are designed to provide a steady stream of income to retirees who fear they may outlive their assets.

An annuity can be immediate or deferred. Immediate annuities are typically purchased by investors who’ve received a large sum of money and prefer to exchange it for cash flow beginning instantly or up to a year away. Deferred annuities are different. They’re designed to grow on a tax-deferred basis, providing annuitants with stable income that begins on a specified future date of their choosing.

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Annuities are usually structured as fixed, fixed indexed or variable. Fixed annuities provide a declared guaranteed interest rate for a set number of years. Some of the more common term lengths are 24 to 72 months. Because of their similarity to certificates of deposit (CDs), some people refer to these as CD annuities. Variable annuities have the potential to bring larger future payments so long as the investments of the funds do well. If the funds do poorly, the payments will be smaller. In other words, your payments are dependent on the success of the investment strategies. Fixed indexed annuities (FIAs) are fixed annuities that offer a return based on the performance of an equity index, like the S&P 500 index. But because they are fixed, contract guarantees protect the contract owner from market losses. FIAs share in the returns of the index they are linked to and its gains, but not in its losses.

As with any investment, there are varying levels of risk involved, so you’ll want to ensure you make the best choice for you and your financial goals. To help you get started, here are a few mistakes you’ll want to avoid.

Not understanding taxation

You should be aware of the difference between purchasing an annuity with pre-tax or after-tax dollars. An annuity purchased with pre-tax dollars, such as in an IRA or 403(b) plan, is a qualified annuity. Non-qualified annuities are those purchased with after-tax dollars. Many people enjoy the additional benefits of not having to pay tax each year on interest earned inside a tax-deferred annuity or the required minimum distributions (RMDs) that come with pre-tax accounts. But keep in mind that while the deposit (cost basis) will never be taxed, the gains inside of the annuity will be taxed at the time of withdrawal.

Are you purchasing an annuity within an inherited IRA? With the SECURE 2.0 Act changing RMD rules, you need to be aware of the annuity’s surrender charge period and the need to deplete the account within 10 years. What about using an annuity in a Roth IRA? A tax-free income stream from a Roth annuity sounds wonderful, but that Roth must be “seasoned” by being open for a minimum of five years before its withdrawals are fully tax-free. As always, consult a tax adviser to give you proper guidance on the type of account you’re looking to open and any potential pitfalls involved.

Not refinancing a low-interest annuity

When mortgage rates are high, the chances are it’s not a good time to refinance a low-interest mortgage. The days of 3% mortgages seem like eons ago. The average 30-year fixed rate reached an all-time record low of 2.65% in January 2021 before surging to 7.79% in October 2023, according to Freddie Mac. If you have a 3% mortgage, with 27 years left on your loan, refinancing at 7% doesn’t make a lot of sense.

On the flip side of the coin, refinancing opportunities currently abound with lower interest-paying annuities. Back in January 2021, fixed annuity rates were paying 2% to 3% due to the U.S. 10-year Treasury being in a very depressed state. The insurance companies that offer annuities themselves invest in long-term, safe investments, such as corporate bonds and government treasuries, mortgages, real estate and policy loans, and price their offerings to clients based on the rates they can get on their own investments at that time. Fast-forward to September 2024, and the highest interest five-year annuities are paying between 4.5% and 6%. It’s not a coincidence that the 10-year Treasury reached a high of 5.021% as recently as October 2023.

The same can hold true for refinancing and upgrading older income-focused annuities. Higher interest rate environments have increased income payout factors and income account value growth for insurance companies. Since they are earning more on their own savings and investments, some of those earnings can be shared with policy owners. We have seen many instances of annuities that have been deferring income for several years being unable to keep up with the guaranteed income available in today’s annuity space. With inflation hitting recent long-time highs, why would you not try to maximize every dollar you can get for future income?

Overinvesting in annuities

While the current rates and income benefits in today’s annuity market can be very alluring, annuities can be a complicated investment with a lot of different factors at play. That is why the type of annuity you purchase, the insurer you’re purchasing it from, your age and your personal situation all impact the right fit in this type of investment.

To use a simple example, if a 70-year-old person has $100,000 of investable assets, it doesn’t make sense for them to invest $90,000 of that into a long-term insurance contract, no matter how good those benefits may be. This is poor diversification, leaves them with little liquidity to address emergencies and is not in the best interest of the consumer.

To ensure you’re purchasing an annuity that suits your needs, be sure to consult with a financial advis e r with annuity experience. A qualified independent fiduciary can help you determine how much to invest in annuities based on your financial circumstances as part of a healthy, holistic retirement plan.

Investment Advisory services offered through Brookstone Wealth Advisors, LLC (BWA), a registered investment advisor. BWA and Brookstone Capital Management, LLC are affiliated companies. BWA and Beckett Financial Group are independent of each other. Insurance products and services are not offered through BWA but are offered and sold through individually licensed and appointed agents. Index or fixed annuities are not designed for short-term investments and may be subject to caps, restrictions, fees and surrender charges as described in the annuity contract. Guarantees are backed by the financial strength and claims-paying ability of the issuer. Please refer to our firm brochure, the ADV 2A Item 4, for additional information. Registered Investment Advisors and Investment Advisor Representatives act as fiduciaries for all of our investment management clients. We have an obligation to act in the best interests of our clients and to make full disclosure of any conflicts of interest, if any exist. Please refer to our firm brochure, the ADV 2A item 4, for additional information.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

JB Beckett has been an adviser for 24 years and is the founder of Beckett Financial Group, a specialized financial firm that helps individuals and businesses in the Retirement Red Zone build Tax-smart Retirement Income Blueprints allowing them the freedom to overcome their concerns about inflation, market volatility and taxes to retire sooner.