Annuities: Friend or Foe?

Gerald D. FaheyAugust 17, 2017

Financial Planning

Clients sometimes ask us about annuity products, such as should they buy one or not or in the case of one already owned, is it best to keep it or not?  If the decision is made to surrender the annuity, what are the tax ramifications of doing so?  We thought it might be helpful to have a closer look at some of the “pros” and “cons” of annuities and how they may or may not fit within the overall framework of financial planning. 

Basically, annuities are insurance products designed to do the opposite of life insurance.  Life insurance provides some protection against premature death while annuities provide some protection against longevity.  First, a few definitions might help with our “deeper dive” into this topic:


Some annuities are classified as “qualified”, funded with pre-tax money such as with contributions made into a retirement account for an individual or through an employer plan.  As with IRA distributions, every dollar withdrawn from a qualified annuity is taxed at one’s ordinary income tax bracket, since money flowing into the account is not taxed until withdrawn.


Annuities that are “non-qualified” are funded with after-tax money, so funds deposited into this type of account represent one’s “tax cost basis”, when determining the taxable nature of any future withdrawals.  For example, if you invest $50,000 into a non-qualified annuity and the account grows over time to $100,000, at which point you make a complete withdrawal of the funds – the original $50,000 would represent your return of “cost basis” for tax purposes and will not be subject to taxes.  We will have more to say regarding the tax treatment of the gains later.

Annuitize or Annuitization

Annuities have two phases; the first is the accumulation phase when a deposit is made and hopefully the contract is growing in value; the second is the distribution phase, also known as the annuitization mode of the contract, when the insurance company makes monthly payments from the annuity.  In the distribution phase, the death benefit in the contract goes away and the payments are made subject to the terms of the contract.  Unless there is a “period certain” mode of repayment or a survivorship death benefit, the insurance company may have the right to keep any residual balance left in the contract, in the event of premature death.  

There are many different types of annuities (and riders), so a brief description is in order:

Immediate Annuity or SPIA (Single Premium Immediate Annuity)

With this type of annuity, an upfront, lump-sum payment (or premium, since it is an insurance contract) is made in exchange for a lifetime (or other interval) income stream paid to the recipient, which is guaranteed by the issuing insurance company.  Depending upon the structure of the contract, one could receive more than, less than or equal to the premiums paid.  There is interest paid and factored into the payments flowing out to the recipient (often identified as the “annuitant” or the one on whose health history and life expectancy the contract is based).  Income payouts for this type of product typically begin within a 13-month period, therefore these are known as “immediate” annuities.  In contrast, a deferred annuity would be one beginning after a 13-month period.

Fixed Annuity

This type of investment pays a stated rate of interest for a fixed period and with tax-deferred interest accumulating until withdrawn.  If you purchased a $100,000, 6-year fixed annuity @ 3% interest, at the end of the 6-year period the account will have grown to $119,405.  If you made this purchase and then closed the account at “maturity”, you would be responsible for the $19,405 accumulated interest on the original investment of $100,000 and it would be taxed at ordinary income tax rates (your marginal income bracket).  The contract is guaranteed by the issuing insurance company, so one should consider the financial strength of the company to buy from. 

Fixed Indexed Annuity

This product is like the fixed annuity noted above but with an opportunity to participate in market “upside”, which is typically linked to an equity market index such as the S&P 500.  If the stock market does well, there is a chance of earning a higher rate of interest, subject to a cap or maximum rate for a given period.  In the event of a declining market, these products often have a “floor”, where you are paid no interest for a given year but also do not lose any of your principal.  There is also a fixed period for your money to stay invested in the annuity (like most annuities), so “liquidity” or your access to the money may be limited during this time.

Variable Annuity

The variable annuity is another type of insurance contract featuring tax-deferred growth and designed as a supplementary retirement account. Your premiums are invested into “sub-accounts” with varying degrees of risk including money market, fixed-income (bonds), equities (stocks) and international (outside U.S.) funds, so account values fluctuate based on market performance and with no guarantees.  

These contracts are often sold with “income riders” with strange acronyms such as a GMIB (guaranteed minimum income benefit), GMWB (guaranteed minimum withdrawal benefit) or an LIB (lifetime income benefit).  These riders attached to the annuity may provide a guaranteed lifetime income stream to the client (guaranteed, if the insurance company is solvent and only until they’ve paid back all the original principal) or in the case of an LIB – even if the contract value has declined to zero.  There are, of course, additional fees charged by the insurance company for the enhanced protection of these riders.

There are potentially other adverse consequences of annuities, which investors should also be aware of:

Contingent Deferred Surrender Charge

Also known as “CDSC” s, many annuities come with a surrender schedule, so in the event you need access to your money before a certain date, there may be a stiff penalty imposed by the insurance company.  There may have been a hefty commission paid at purchase (such as 7 – 10%) of the annuity and if so, there could be a corresponding penalty (such as 7 – 10%) if you want to get out of the contract. 

Net Investment Income Tax

Income from non-qualified annuities may trigger the net investment income tax of 3.8% (applies to adjusted gross incomes greater than $200,000 for single filing status and $250,000 for married filing jointly).

Step-Up in Basis

Unlike many other investment products such as stock, bonds, etc., non-qualified annuities do not result in a basis “step up” at death; so, at death in a non-spousal beneficiary situation, all deferred earnings in the annuity would be taxed as ordinary income rates and not capital gain rates.

State Guaranty

Many states provide this protection to the consumer up to $100,000, in the event of insolvency on behalf of the insurance company.  However, if your aggregate ownership of annuities is greater than $100,000 and you have not “annuitized” the contract, your coverage may be limited and less than you think.

So, there are many different aspects to annuities and as always, we are most interested in what is in the best interests of our clients, so here is what we tend to focus on:

Liquidity:  One of our core beliefs is that clients should have 100% liquidity to their assets at all times.  Therefore, an annuity product may by contract allow access through a 10% liquidity window each year or direct an investor to annuitize the contract to effect a distribution phase versus our own, we prefer to maintain the full liquidity approach for our clients.

Taxation:  Whether qualified money is coming out of an IRA or an IRA annuity, all distributions are taxable at ordinary income rates, so there is no difference there.

With non-qualified money coming from taxable accounts, the client pays capital gains rates on realized gains from the sale of stocks or bonds (0 –20% for highest income bracket) and ordinary income taxes on some interest and dividend income (0 – 39.6%).

With non-qualified money coming from annuities (after August 13th, 1982), full or partial withdrawals are taxed as ordinary income rates to the extent the contract value exceeds basis.  So, in the case of the annuity purchase noted earlier where the $50,000 invested grew to $100,000 in value in a non-qualified annuity – the entire $50,000 gain would be taxable at ordinary income tax rates (0 – 39.6%).

In the case of an annuitized non-qualified contract, each distribution is pro-rated based on an inclusion ratio calculation (deposits made into contract/accumulated value of contract multiplied by distribution amount) and exclusion ratio which is a pro-rated calculation of return of principal.

Investment Platform:  Annuities typically offer an investment platform of approximately 30 – 50 funds from multiple sub-account managers.  As an independent RIA and through our Schwab platform, we can offer investors thousands of different fund choices from hundreds of different fund families.  In addition, we purchase the institutional share class for our clients, which is the lowest cost share class available in the marketplace within actively managed platforms.

Fees:  Within our overall fee structure, clients pay an investment management fee, a Schwab trading fee for transactions completed on their behalf and internal fund expenses for any mutual funds held in the account.  A typical fee arrangement for this scenario might approximate 1.5%.

With an annuity, the investor may be paying fees for mortality and expense (variable annuity only), investment management, income riders and administration.  We have seen some instances where total annual expenses for a variable annuity contract with an income rider are greater than 3.5%!


When asked by clients about annuities, our response is generally that due to the stated reasons of full liquidity, greater tax-efficiency, a more diversified investment platform offering institutional share classes, an overall lower cost framework and full transparency – it is usually difficult to conclude that an annuity is in the best interests of the client.  Annuities with guaranteed income riders may present the investor with a tempting option.  However, within our fiduciary responsibility to clients and in financial planning, where we are driven by an assessment of probability of success – we think that in most cases, investors have better choices than annuities.  



Benefit Rider or Annuitization
The Tax Treatment of Income from an Annuity
Taxation of Annuities Explained
NAIC – Annuities
PA Life – FAQ
The Nest – Annuitant vs. Owner
Morningstar – Variable Annutiy
Morningstar – What’s a Variable Annuity?
Annuity FYI – Compare Top Lifetime Income Benefit (LIB) Annuity Riders
Annuity FYI – Lifetime Income Benefit Provision
National Organization of Life & Health Insurance Guaranty Associations
Insure.com – The Basics of Annuities