A tax deferred fixed annuity can be a useful retirement investment. These investments earn a guaranteed rate of return while also delaying taxes on your investment gains. Despite these benefits, tax deferred annuities also have some serious disadvantages. Make sure to consider both the pros and cons of these plans before investing in one.
One of the reasons why annuity companies guarantee a rate of return for annuities is because they are long-term investments. You are supposed to keep the money in the annuity for a minimum amount of time, usually five to seven years. If you want to take out money before this time, your annuity company will charge a penalty known as a surrender charge. According to CNN Money, the average annuity charges a 7 percent penalty on withdrawals in the first year. Every year after that, the charge drops by 1 percent until you can start making withdrawals with no surrender charge in the eighth year.
Early Withdrawal Tax Penalty
As long as you keep your investment gains in your deferred annuity, you won't owe income tax on the gains. The IRS created this benefit to help Americans save for retirement. In exchange, you are supposed to keep the money in the annuity until you are at least 59 1/2. If you take out money before then, you'll owe income tax plus a 10 percent penalty on part of your withdrawal. You won't owe these taxes when you take out your contributions into the plan, but you will when you take out your investment gains. For example, say you deposited $10,000 into an annuity and earned $5,000 through the investment. You would be able to take out $10,000 tax-free, but the $5,000 of earnings are taxable.
Low Upside Potential
A fixed annuity pays the same return regardless of what happens in the stock market. If you buy a contract with a five percent annual rate of return, your money will grow by five percent every year no matter what. This is a nice benefit when the market is doing badly because you'll always make money. The downside though is that it also means you won't share in the gains when the stock market does well. Since there is no way to increase the rate of return on your fixed annuity, you're stuck earning a flat rate.
No FDIC Insurance
Unlike bank accounts and Certificates of Deposits, tax deferred fixed annuities do not have FDIC insurance. This means that if your annuity company goes bankrupt, the government will not pay to replace your lost savings. While most companies that offer annuities are financially secure, some have gone bankrupt in the past. Before investing with a company, you should check its credit rating with an independent rating agency like A.M. Best. These agencies review the safety of each annuity company and record if a company ever missed payments to its customers.
Dylan Armstrong specializes in insurance, investing and retirement planning. He has also worked as a life and health insurance salesman and holds a Bachelor of Science in finance from Boston College.