When financial institutions hold and invest funds with the purpose of issuing fixed revenue payments in the future, they are making a contract called an annuity. Very often, annuities are sold to people who seek to preserve income in the event that other retirement sources become exhausted. The initial stage of an annuity is when the investor accrues the funds for eventual disbursement.
When an agreed-upon amount is gathered, the recipient then begins to draw funds in fixed or variable installments, for a specified period or until death. Alternatively, owners of annuities can request lump-sum payouts.
What Fees Are Associated with Annuities?
As a rule, the more complicated an annuity product, the higher the fees will be. For instance, a variable annuity is pegged to particular investment portfolios or indexes, e.g. the S&P 500, whereas a fixed annuity is not. Therefore, when an index rises or falls, so too does the payout. Changes like this result in fees, averaging about 2.5 percent of the contract value.
Meanwhile, many annuities have custom provisions based on the contract between institution and customer. These individualized terms are called riders, each coming with its own fee. The fee could range between a quarter to one percent of the annuity value.
Simply entering into an annuity agreement requires a commission to be paid to the institution, which can sometimes get 10 percent of the contract's worth. Moreover, there are administrative fees and financial penalties for taking funds outside of the contracted schedule.
Are Annuity Fees Tax-Deductible?
Unlike other investment instruments, fees paid on annuities are generally not tax deductions. The reason they are not tax-deductible is that the Internal Revenue Service looks at the income from annuities as ordinary income, akin to salaries and wages, as opposed to capital gains because fees are paid out of the revenue annuities produce.
As an employee spends part of a paycheck toward transportation costs, fees are considered standard expenses. Furthermore, since an annuity is a contract, paying fees is simply one of the contractual terms. For these reasons, while it may seem unfair or illogical to some, annuity service charges are non-deductible in 2021.
Are Other Investment Fees Tax-Deductible?
The Tax Cuts and Jobs Act of 2017 pared down the number of investment-related expenses eligible for deduction. The criterion is that such fees must be directly related to the creation of investment revenue.
For example, prior to 2017, fees for financial investment consultations, accounting services and Individual Retirement Fund (IRA) custodial maintenance were all deductible. They are no longer. However, those who itemize deductions can include expenses related to interest income as long as those costs do not exceed the net taxable income from investments. In addition, interest paid toward loans or credit obtained for business purposes are also subject to write-off.
Does This Mean Annuities Are Not Wise Investments?
The many investment instruments and products all have pros and cons. Annuities are attractive because they are easily customized to the individual. Also, they offer a guaranteed income along with assistance in money management. The insurance companies that issue annuities are usually quite strong financially, making good on the promise of lifetime payments.
At the same time, each customized provision, or rider, is expensive, as noted above, as are the associated service fees. All count toward taxable income. Whether the positives are worth the drawbacks is a question that must be answered on a case-by-case basis.
Do the costs related to an annuity make a huge dent in the revenue it provides? Would tax-deductibility mitigate that dent? Each investor must address this on her own.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.