An annuity contract is one of the most difficult documents to understand for a reason. You may already know that I’m no fan of annuities. In fact, I think you should never buy an annuity – especially now because interest rates are low. If you fall for the annuity sales pitch, you’re going to lock in these low rates for years to come and regret it.
Beyond this, annuity contracts make your money unavailable to you– most people who own annuities die owning them. That’s because they don’t want to pay ordinary income tax on the growth — and that’s exactly what happens when you make withdrawals of the growth. As a result, they just leave the money in and allow their estate to deal with the tax problem.
But if you’re still enamored by the annuity after all that, here are a number of things to check in your annuity contract before you sign the dotted line:
1. Interest Credit
Often you’ll get a very high teaser rate to sucker you into a long-term contract. Then in subsequent years, the insurance company will pay you a very low rate of return on your money. Since you signed the long-term contract, you can’t get out of it without paying a huge penalty. So what looked great at first turns out to be a terrible investment for retirement income. Make sure this doesn’t happen to you.
You can safeguard yourself by only owning a multi-year contract. That simply means the interest you will receive is guaranteed for the life of the contract. Don’t sign a 10-year contract just because the current rate is 7% today. Make sure the insurance company is straight with you about the rate they are going to pay you for as long as your money is invested.
2. Two Tiers
This is a favorite trick of the insurance company. If you have a two-tier contract these companies offer you one amount if you withdraw your money over your lifetime. This is called the annuitization value or tier 1. It turns into an immediate annuity payout. But if you want the entire balance at one time (to roll it over to something better for example); they’ll likely reduce the value of your account by 10-20%. That’s the tier 2 value.
This is a complete rip-off and should be illegal. Unfortunately, teachers and employees of the state get sucked into these annuity contracts all the time.
The way to avoid this problem is to make sure to ask if this is a multi-tier product. Also ask if there are any penalties once the surrender charges are up. In other words, ask what penalties apply if you take out the entire amount at any time in the future.
3. Surrender Period
Regardless of what your agent says, read your annuity contract. Make sure you understand when the surrender period is through. That’s the time when you should be able to take all the money without a penalty.
Most annuity contracts offer 10% withdrawal amounts. That’s OK, but what’s better is cumulative withdrawals. This means that if you don’t take the first withdrawal of 10% in year 1, you are able to take 20% in year 2 without a penalty. If you don’t take that withdrawal, you would be eligible to take a 30% withdrawal in year 3 with no penalty, and so on.
Make sure that your withdrawals are cumulative if access to your money is important.
5. Joint Annuitant
Every annuity contract asks you to name a beneficiary and an annuitant. That’s the person the contract is based on. If that person dies, the owner is often forced to take the money out of the contract (either immediately or over five years). What you really want is to have a joint annuitiant so if one dies, the other can keep the contract going.
Look, if you buy an annuity, you probably do so because you find the tax deferral attractive. I’ve already explained why you should never buy an annuity, but if you insist on buying one of these ugly bugs at least get the best one possible. By owning an annuity that allows you to name a joint annuitant you’ll be able to continue deferring the income for a much longer period of time.
What other traps have you encountered with annuity contracts?