What you don't know about annuities

The Best Annuities for Retirees

If you're like many Americans, you've found yourself considering incorporating annuities into your retirement savings plan at one point or another. The concept may seem both simple and attractive – giving up some money now so you can have money later – but the truth is that annuities are much more complex and less of a guaranteed income source than brokers or other salespeople would have you believe.

One major drawback to annuities is the considerable amount of fees. Unlike mutual funds and/or exchange-traded funds, you are required to pay additional fees, such as mortality and expense charges as well as surrender charges – not something suited for a long-term investor. In addition, the insurance companies selling the annuities often layer on annual fees, which can range from 1.3 percent to 3.5 percent. All of these fees add up over time and can put a significant damper on your returns.

Another critical consideration when it comes to annuities is the small print. If you don't review everything carefully, you may pay for your lack of attention in more ways than one. Recently, the Financial Industry Regulatory Authority and the U.S. Securities and Exchange Commission have issued several investor alerts on annuities and the unique issues associated with them. For example, some annuities are so complex that their prospectus is more than 150 pages and others have been called out for having high commissions and other hidden traps.

Taxes are another important, often-overlooked detail. When you withdraw money from an annuity, the gains are considered ordinary income and can be taxed by as much as 35 percent at the federal level. By comparison, when you sell a mutual fund, the money you receive is considered a long-term capital gain, which incurs a tax rate no greater than 15 percent.

If you've begun exploring annuities, you may know there are three primary types, each of which has its own unique set of pitfalls of which to be aware:

1. Fixed annuities.

These are frequently considered the least complicated of the three since they have a fixed interest rate (hence their name). However, they often forfeit any remaining money to the insurance company rather than pay it to beneficiaries if the owner dies before the contract expires.

2. Equity-indexed annuities.

These can appear enticing for guaranteeing a minimum interest rate while providing the opportunity for greater gains if the stock index to which they're tied performs well. But insurance companies often set strict caps on maximum annual returns. So if the market rises 60 percent, for example, don't get too excited. Your annual return may be capped at 10 percent, resulting in much less profit than you may have anticipated.

3. Variable annuities.

This class catches the attention of many with no annual contribution limits and a broad array of investment choices, but beware of their commission fees – they're among the highest in the investment industry. Also, the taxes associated with variable annuities are frequently greater and more complex than you'll find with other annuities or investments.

The bottom line is that it's imperative to thoroughly research the details of any annuity and make sure you understand them before you invest. An easy way to do this is to talk with a reputable investment advisor. He or she can be a valuable resource who can help you decide not just whether an annuity is right for you, but which type of retirement savings vehicles overall are best for your personal goals and financial well-being.

Copyright 2015 U.S. News & World Report

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