Disadvantages Of Fixed Annuities
There are several fixed annuity disadvantages that potential buyers need to be aware of before a purchase. These disadvantages include a 10% tax for cashing out an annuity before the age of 59.5, as well as surrender charges for early termination.
The Top Fixed Annuity Disadvantages
Fixed annuities offer many advantages for retirees, however there are some fixed annuity disadvantages to consider. As with all investment options, it is a matter of weighing both the good and the bad attributes.
- 10% IRS Penalty – The IRS imposes a 10% tax penalty on any annuity withdrawals taken prior to the age of 59.5.
- Income is taxed as ordinary income – Any gains or income received from a fixed annuity is taxed as ordinary income.
- Complicated Contracts – Complicated fixed annuity contracts make them difficult for consumers to understand.
- Limited Liquidity – Fixed annuity contracts limit access to your funds.
Understanding the IRS 10% Penalty
Cashing out money from any annuity prior to the age of 59.5 will result in a 10% tax penalty on top of the ordinary tax rate. This means a potential tax rate of 45% on gains. Needless to say, the IRS penalty can substantially eat into your growth. However, there are some silver linings to this particular fixed annuity disadvantage.
The IRS will never assess taxes on your principal. The 10% IRS penalty applies only to the gains you accumulate after you purchase the annuity, so your initial investment would be exempt from the fee. At worst you make less money; you never lose money.
Following the rules within the tax code will allow you to completely avoid this penalty. For an immediate fixed annuity, don’t invest unless you’re over 59.5 years of age. For a deferred fixed annuity, make sure you’ll be over 59.5 when it comes time to withdraw income. You always have the option to rollover one annuity into another. You needn’t worry about timing the contracts maturity date to your 60th birthday.
Additional ways in which to avoid the 10% penalty include:
- Death or Disability of the Annuitant: The IRS waives the 10% penalty if the annuitant dies or becomes disabled
- Annuitization: If you choose to disburse the annuity within one year of signing the contract (otherwise called Annuitization), the IRS tax penalty is waived
Fixed Annuities Are Taxed As Ordinary Income
Don’t mistake tax-deferred growth with tax-free growth. While the annuity is active, your money will grow tax-free. However, when you or a beneficiary starts to withdraw income, it will be subject to the ordinary tax rate of the individual making the withdrawal.
Why is this a negative? Stocks, mutual funds, and similar investment options pay the more favorable capital gains rate of 15%. In a worst case scenario your tax bracket could be as high as 33% when considering state & federal taxes. That’s more than double the 15% capital gains rate.
Another fixed annuity disadvantage is that they tend to be overly complicated. This makes it difficult for investors to determine if they are receiving value for their money. The average investor may not have the knowledge or expertise needed to fully understand their contract, which can lead to errors in judgment.
Fixed annuity contracts tend to be complicated and confusing. Because they involve many different features and add-ons, fixed annuities can be difficult for even experienced investors to understand fully. In addition, many products on the market today offer features that don’t necessarily benefit their users in any way. This means that it’s easy for investors to pay extra money for features they don’t need or want.
Fixed annuity contracts tend to be complex and have many restrictions. The fine print for annuities can be confusing but insurance companies that offer them are required by law to disclose all the details of their policies. You need to read the contract carefully before you sign it and make sure you understand all its terms.
When you buy a fixed annuity, you are giving up the ability to withdraw your money for a certain period of time. That is not necessarily a bad thing, but it does mean that you need to be sure that you can handle not having access to your money for a certain period of time.
Fixed annuities also have limited liquidity (the ability to get your money out if you need it). Most annuities offer “free withdrawals” of up to 10% per year or they allow you to withdraw the interest you earn each year.
Exceeding those withdrawal limits will trigger a surrender charge. If you purchase a 10-year fixed annuity and decide that you want access to your money after 5 years, there’s no way to do so without incurring a penalty. In other words, if something unexpected happens, such as an emergency requiring immediate funds or an opportunity that is too good to pass up, then you would have no choice but to surrender your contract and take a loss.