Are Your Annuities Holding You Back? What you need to know about keeping, surrendering, or exchanging your annuity.
Annuities can be a controversial subject. In the financial world, it seems you fall into one of two camps; you either love annuities or you despise them!
An annuity is a financial tool just like any other. It can have its positives and negatives. And like any financial tool, there are different options and nuances when it comes to deciding which ones (if any) make sense for you.
My problem with annuities, and the reason they get a bad reputation, in my professional opinion, is Annuities Are Not Bought, They Are Sold!
When you incentivize a 7% to 10% sales commission (i.e. load) on any financial product, a motivated salesforce is going to find a way to sell it.
Non-fiduciary “financial professionals” sell annuities to clients whom understand little about comprehensive financial planning. Why? Because these registered representatives will often earn a large commission on the sale. Most know little about their efficacy in a financial plan, and often, do not truly care about the clients’ best interests as long as their personal compensation increases.
These “professionals” position annuities as a guaranteed, no-risk, safe haven investment vehicle where you can earn guaranteed income in retirement.
As of today, there is no contribution limits on annuities, unlike with traditional IRAs and Roth IRAs. Like an IRA your money will grow tax deferred. When the money is withdrawn, only the earnings are taxed, whereas your original contribution is tax-free. Sounds appealing.
Then what can be so bad about annuities?
First, contrary to what may be presented by advisors selling annuities, these financial tools are not without their own risks and consequences.
1. Most annuities are subject to both investment risk and inflationary risk. Their returns may underperform the stock market or fail to outpace the rate of inflation.
2. As my father always told me, nothing in life is guaranteed. The insurance company (not the federal government) guarantees these annuity payments. If the insurance company backing your annuity files for bankruptcy, you may not receive the “guaranteed” income you anticipated. When you buy an annuity, it is important to consider the financial strength of the underlying insurer.
3. I have seen advisors recommend most or all of a retirement portfolio be transferred into an annuity. And even worse, supplementary income is no longer a retirement need of the client! It is almost never a good idea to carry all your investable money in one basket. This can disregard the simple financial rule of diversification.
4. Annuities often carry high underlying fees which will put a significant drag on your investment returns. More specifically, a variable annuity will often come with annual fees in the range of 2.25% – 3.00% per year.
5. Annuities can be difficult to unwind (without paying high surrender fees). What is known as the surrender period can vary from 2 years to 10 years or more.
The surrender fee will typically decline overtime. For example, an annuity with a 7-year surrender period would charge 7% on a surrender in the first year, 6% the second year, 5% the third year and so on.
6. It can be difficult and costly to access cash from an annuity should you find yourself in need of a large cash withdrawal in the case of an emergency.
7. Annuities can provide a more tax-sheltered way to save for retirement. The growth is tax -deferred until distributions begin like your 401(k) or IRA. An annuity was purchased inside an IRA? An IRA is already tax deferred; you do not receive a double tax deferral benefit if you buy an annuity inside of your IRA.
So, then, why do so many individuals end up with a large percentage of their total investable assets in annuities?
Unfortunately, it often comes down to poor financial guidance and the choice to place personal best interests ahead of your own.
Yes, there are exceptions. The QLAC (Qualified Longevity Annuity Contract) or a deferred/immediate fixed annuity strategy are reasonable to consider which I’ll cover more in depth within a subsequent article. There are, certainly, appropriate uses for annuities, but you must thoroughly research and understand all your options beforehand.
Regardless of how you got into your annuity, it is important to work with your CERTIFIED FINANCIAL PLANNER™ in understanding your next best, available options.
Your Available Options
Your options for surrendering or exchanging an annuity can be limited and will depend on asset location of the annuity—within an IRA or outside of an IRA (i.e. nonqualified)—and whether you are already receiving benefits.
Option 1: If your annuity Is In an IRA, you can complete a trustee-to-trustee transfer.
To avoid paying taxes, you may elect to roll your funds out of the annuity and into a rollover IRA at your new custodian. You would close the annuity and transfer the IRA as a trustee-to-trustee transfer, similar to your 401(k) rollover at retirement, deferring the tax liability.
Since the funds are still within the “IRA wrapper”, you avoid having to take your money as ordinary income. It is important to first work with your CERTIFIED FINANCIAL PLANNER™ to confirm the surrender period has ended as well as review any riders that may have been added to your initial contract.
Option 2: If your annuity Is Not held in an IRA, you can Surrender it.
As previously discussed, if you are within the surrender period, you will typically be assessed a surrender charge—a percentage of the total amount withdrawn. I have seen these reduced or waived if your able to present a case for negligence or irrevocable terminal illness. Consider this negotiable within reason.
Surrender charges will typically diminish as time passes, so it could make sense for you to wait a few years before exercising the option to surrender.
You will not be taxed on the portion of your withdrawal that represents a return of your original principal. Only your earnings will be taxed in a nonqualified annuity.
Nonqualified annuities use the exclusion ratio to determine how much of your withdrawal is principal and how much is earnings. Earnings from a nonqualified annuity are taxed at ordinary income rates.
Option 3: If your annuity Is Not held in an IRA, you can use IRS Section 1035 Exchange.
A Section 1035 exchange is a provision in the Internal Revenue Service (IRS) code allowing for a tax-free transfer of an existing annuity contract for another annuity of like-kind.
Both Full and Partial 1035 exchanges are permitted, although some rules will vary by annuity contract.
If your annuity has profit/earnings, you will pay ordinary income taxes on those gains. However, if the gain is substantial—a surrender (Option 2) could cause a significant tax consequence—instead, elect to exchange your current annuity for a no-load (commission free) annuity with lower annual expenses.
This is called 1035 Exchanges. Speak with your CERTIFIED FINANCIAL PLANNER™ (CFP) and Certified Public Accountant (CPA) regarding your options.
Option 4: Find a buyer.
If you have a standard income annuity, you may be able to find someone to buy you out. In other words, if your annuity is already paying out an income benefit, you may be able to find someone who will offer you a lump sum dollar amount for your contract.
Selling an annuity is a legal process and you would want to speak with your CERTIFIED FINANCIAL PLANNER™ and Legal Counsel about whether selling your annuity is the right decision.
On average you can receive between 60% to 80% of what the annuity is worth in cash value. Due diligence and negotiation on your cash offers will increase your potential payout. Most companies should provide you quotes or estimates free of charge.
Your Next Move
Not sure if you should keep, surrender, or exchange your annuity?
At Aventine Financial Group LLC we are independent certified financial professionals whom specialize in designing time-tested wealth-building investment portfolios for individuals and families alike.
As fiduciary wealth managers, we do not sell annuities or any other financial products for commissions. The financial advice we offer is based 100% on our desire to see you reach your financial milestones and achieve financial freedom.
Frank J. Fiumecaldo, CFP
Founder & President