- Annuities may be a good investment, but investors should weight pros and cons before spending the money on it.investment image by Kit Wai Chan from Fotolia.com
Money magazine defines an annuity as "an insurance product that pays out income, and can be used as part of a retirement strategy." Life insurance companies commonly offer annuities, according to the Christian Science Monitor. Annuities operate as follows: An investor pays the insurance company a lump sum of money; in return, the annuity pays income to the investor over time. Variable rate annuities have some disadvantages. - According to freeannuityrates.com, many variable annuities require the investor to pay various expenses on the annuity that tend to take away from the overall return of the annuity. For example, some variable annuities come with "annual expenses" (generally defined to be various administrative and account-caretaking expenses) that could be 3 percent of the annuity or more. Additionally, variable annuities tend to come with high "surrender charges." A surrender charge is similar to an early termination fee; if the investor pulls out the money before the investment matures, that investor may have to pay 5 to 10 percent in fees to terminate the contract.
- Additionally, variable annuities (and fixed annuities) are generally sold by commission. This means that investors may have to pay a large percentage of commission just to own the investment.
- "Basis" is a tax and accounting term that, generally speaking, refers to the amount of money an investor paid for the investment. A "step-up" basis means that if the investment is inherited or transferred, the person receiving it has a basis in the current value of the investment---not the original cost. Therefore, if an investor paid $10 for the annuity, but dies and leaves the annuity to an heir, the basis remains $10. Therefore, if the new owner sold the annuity, the new owner would have to report income gained based on the original basis. So, if the cost was originally $10, but the annuity is valued at $100, the new owner will realize a gain of $90. Had the variable annuity included a step-up in basis, the new basis would be the current value ($100), not the original cost ($10). This makes variable annuities a poor choice for estate-planning reasons: You generally do not want to stick your heirs with tax liability if you can avoid it.
- Gains from variable annuity disbursements must be reported as ordinary income on a taxpayer's tax return. This varies from other investments such as mutual funds, which are not taxed as ordinary income and can be tax deferred. Ordinary income is generally taxed at a higher rate than other forms of income, such as capital gains. The tax consequences of a variable annuity make variable annuities less lucrative.
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