A retirement annuity is a defined contribution retirement account sold exclusively by life insurance companies. The earnings within a retirement annuity are tax deferred until withdrawal. Insurance companies can offer a variety of guarantees with their retirement annuity products, but these benefits come with extremely high fees.
As a retirement investment, a retirement annuity has both advantages and disadvantages:
- Tax deferred growth within account
- Guaranteed benefits
- No limits like a 401k or Individual Retirement Account (IRA)
- Extremely high fees
- Lack of liquidity, 10% early withdrawal penalty
Benefits of a retirement annuity
The main benefits of retirement annuities are the guarantees that life insurance companies provide. These can include a guarantee that you will receive a minimum income per year after retirement and guarantees that the accounts value will be at a certain level in the future. The income earned within an annuity is tax deferred upon withdrawal providing a tax shelter for potential investment growth.
Disadvantages of a retirement annuity
These benefits come at a cost. The fees charged on annuities can be extremely large and are highly criticized in the financial world. The total amount of fees charged on an annuity are around 3% a year, a far cry from the 1% a year charged by mutual funds directly. Here is a breakdown of what kind of fees you can expect to see when purchasing a retirement annuity along with the typical amount of the fee:
Insurance Fee (1.4%) – This is also called the mortality and expense fee (M&E). The consumer is told this fee goes to pay for insurance costs for the guarantees they receive from the retirement annuity.
Investment Fees (1%) – These are the fees charged on all of the investments in the annuity account such as the fees for a mutual fund.
Option Fees (.6%) – These are fees charged on the different options that can come with an annuity including guaranteed income to heirs,
Surrender Fees (2.95%) – These fees can be charged when you attempt to withdraw your money from the annuity account.
Additionally, as with 401k or Individual Retirement Accounts (IRAs), there is a 10% early withdrawal fee if you withdraw the money before age 59 ½.
Taxation of Retirement Annuities
The income earned within a retirement annuity is deferred until withdrawal. Once the income is being withdrawn it is taxed according to income tax rather than the capital gains tax. Given that the capital gains tax is 15%, you would have to be in the very lowest income tax bracket to get such a rate, which is generally lower than a retiree will have saved up for their yearly income upon retirement. This requires a wait of up to 20 years before the tax deferred benefits on the accumulation of returns makes it more worthwhile than a non tax deferred investment vehicle.