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Annuity Contract Traps to Avoid

by Neal Frankle, CFP ®, The article represents the author's opinion. This post may contain affiliate links. Please read our disclosure for more info.

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.

Annuity Contract 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.

4. Withdrawals

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?

 

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Comments

  1. MrBill says

    December 11, 2017 at 9:32 AM

    I have $1.4 in my IRA which is managed by a semi-retired friend who worked for State Street. Since 2011, I have the same $1.4 now as I had then. Right now I’m invested 55/45 equities to bonds. It seems that if the market takes a significant dip like it did in 2008, I’d never recover. I’m thinking of investing through a firm called “Accelerated Wealth” here in Colorado Springs. They diversify their annuity with 3 different companies. I need to have annuities yield me about $5500/month in a joint annuity which would reach zero in 30 years assuming one of us lives to age 95. Not concerned about leaving a pot of money for family members. They tell me I can take withdrawls from time to time with no penalties. Think that might be a good strategy to switch over to annuities?

    Reply
    • Neal Frankle, CFP ® says

      December 21, 2017 at 9:51 AM

      In order to know, I’d have to learn more about your situation. If you are interested, let me know. Thanks, Neal

      Reply
  2. PETER G GROSS says

    July 3, 2016 at 1:01 PM

    It is an important point to get the best annuity if and when one gets an annuity.
    Remember, the real purpose of an annuity is to obtain a predictable income stream.
    Is a lump sum better than an income stream?
    This question has a meaningful answer only at the personal level, because both the lump sum and the income stream have advantages and disadvantages.
    The clear danger of a lump sum is that its management requires the type of discipline that most people do not have.
    Therefore, it is personal.

    Reply
    • Neal Frankle, CFP ® says

      July 3, 2016 at 9:13 PM

      Thanks. However, I think there are far better ways to create retirement income. https://wealthpilgrim.com/best-investments-for-retirement-income/

      Reply
  3. becky mcgallion says

    September 29, 2014 at 7:31 AM

    I have an annuity that pays me monthly for lift or 30 yrs if I die. Now I called them to see what this is worth and why I never get a statement and was told that it’s a guaranteed value stream and has no cash value. I’m curious how that could be and need some advice. Anyone got an answer for this one?

    Reply
    • Neal Frankle, CFP ® says

      September 30, 2014 at 12:47 AM

      Hi Becky,

      Thanks. It has no cash value because you can’t cash it in. You could sell it but the insurance company itself won’t give you a lump sum. What you have is an income stream and that’s it. This is one reason I don’t like these immediate annuities. Did they disclose this to you when you purchased it?

      Reply
  4. jb says

    April 14, 2011 at 6:26 PM

    Annuities are simply a financial planning tool. There is no one tool that works in every situation. Annuities have there purpose when used properly. I would curious to know what Neal
    thinks is a better substitute for what an annuity does. Tax deferral, guaranteed income for life (without annuitizing), best guaranteed rates of fixed vehicles. No or low fees (fixed annuities). Don’t throw the baby out with the
    bath water.

    Reply
  5. krantcents says

    March 31, 2011 at 10:08 AM

    I came into teaching after 30+ years in the business world. 99% of my investment choices for my 403B are annuities. Apparently, the decision makers do not believe in choice.

    Reply

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Who is Neal Frankle

Neal Frankle

I'm a CERTIFIED FINANCIAL PLANNER™ Professional with more than 25 years of experience. I feel very blessed and hope to share my personal financial experience and professional wisdom with readers of WealthPilgrim.
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