Don’t Wear Your Raincoat in the Shower 10/28/07
Stewart H. Welch III, CFP, AEP
Founder, The Welch Group, LLC
Don’t Wear Your Raincoat in the Shower
Does it make sense to invest your IRA through an annuity? Annuities continue to be sold in record numbers…often within an IRA. While annuities do offer some advantages, buying an annuity in your IRA is a bit like taking a shower while wearing a raincoat. The raincoat is simply “in the way”. The primary advantage of an annuity is income tax deferral on all dividends, interest, and capital appreciation. Since an IRA already has these features, buying an annuity rarely makes sense for an IRA or other retirement plans.
The up-front and ongoing expenses of an annuity can be relatively high. It is estimated that the average annual expenses for an annuity equals 2.1%. Some companies offer annuities with much lower expenses (Vanguard and Charles Schwab are examples) but you will also find companies that have expenses that are much higher. Remember that having higher expenses reduces the growth potential of your investments.
When you are buying an annuity, you select either a fixed or variable annuity. With a fixed annuity, the insurance company pays you a fixed rate of interest that will change every year or every few years. Some companies offer what I call a ‘teaser’ interest rate. This teaser rate looks very attractive compared with current interest rates and is guaranteed for a year or a few years after which the company has the right to change the rate. The problem is that the insurance company can change your interest rate but you can’t change your policy during the first few years without incurring a surrender charge (see below).
With a variable annuity, you can choose among a dozen or more mutual funds, typically with fund choices across a variety of investment classes such as large, small and international stock funds; money market, short, intermediate and long-term domestic and international bond funds. Still your choices are limited and many of the best funds and fund managers will not be available to you.
Many insurance companies impose surrender charges if you take your money out of your annuity during the first several years. The surrender period can range from five to ten years or longer and the surrender charges will typically be 5% to 7% or more. Usually, these surrender charges decline each year you own your policy. One of the main purposes of the surrender charge is to reimburse the company for commissions already paid out to the selling agent or to cover the ‘teaser’ rate that was offered to entice you to buy their product.
What should you do if you already have your IRA in an annuity? First, check to see if the surrender charge period has expired. If so, you can simply “roll-over” your IRA annuity to a regular IRA. If you would incur surrender charges to rollover your IRA annuity, then your best bet is to keep your annuity until the surrender period ends and then do the rollover. Understanding annuities can be tricky, so it is best to seek the help of a qualified financial advisor before making a final decision.