By: Andrew Rosen, CFP®, CEP®

Despite being one of the oldest investment vehicles out there annuities are still probably one of the most misunderstood investments on the market.  They come in every shape and size and can certainly be confusing.  Figured I’d take a few minutes to help educate us all on what an annuity is, and where it might be an appropriate fit.

The Basics:

An annuity is an investment vehicle handled through a contract between you and an insurance company.  There typically is some form of surrender period once you invest at which there would be a penalty to take your entire funds out, although most annuities allow for 10%/year to be withdrawn penalty free.  An annuity then invests your money in some underlying investment spanning the spectrum from sub-accounts that work very similar to a mutual fund to fixed accounts that resemble CD’s.


A common theme most annuities have is at some point they will annuitize.  What this means it that essentially they’ll turn into a predictable income stream for some period, often one’s lifetime or even them and their spouses life time, in exchange for giving up ownership of the investment.  Easy thing to think of is taking the lump-sum option of a pension vs. taking the income stream.  It is important to know what your annuitization rate will be based on when your investment flips to annuitization as it can be as early as immediately to as late as age 95 or older.

Tax Treatment:

Annuities fall under a different category of tax treatment than most other investments.  An annuity gets taxed essentially the same as cash value accumulation in a life insurance policy.  In fact, you can even transfer the cash value from an existing life insurance policy into an annuity tax free, referred to as 1035 exchange.  The investments in an annuity grow tax deferred until you go to withdrawal.  Upon withdrawal you are taxed first on the growth over contributions at ORDINARY income tax, unlike the long or short term capital gains tax rates that other investments are generally taxed at.  Once you pull out your growth, which is what is assumed to be your first withdrawal, you are then typically receiving principal and not taxed at all.  If the account value goes down to zero then all future payments received will be taxed again at ordinary income tax rates.  Also it is important to know that if taking growth out before 59.5 you may be hit with an additional 10% penalty on the growth amount, much like an IRA.  There can be certain ways around it like rule 72t, but more on that in another blog article.

When to Purchase:

I find that annuities are certainly not appropriate for many people.  That said there are situations where I think annuities are a nice compliment to one’s investment portfolio and/or make plenty of sense.

  1. When someone would really benefit from the tax shelter.
  2. If you are searching for products that offer a death benefit feature.
  3. If giving up control and flexibility for predictable and sustainable income stream.
  4. As a pension replacement or compliment.
  5. If dealing with normal market volatility is something you cannot stomach.
  6. When transferring dollars from cash value of an existing life insurance policy.
  7. Typically as retirement gets closer.

When Not to Purchase:

As there are times when it makes good sense to acquire an annuity there are also plenty of times I don’t find it makes much sense.  Speaking in generalities, as there are exceptions to every rule, below are the times I would most likely not recommend an annuity.

  1. If you need easy access to your funds.
  2. If you are on the younger side of working and accumulating assets.
  3. For 100% of your liquid assets.
  4. If your risk tolerance is high.
  5. If your income needs are not a concern or being met through other means.
  6. If you are extremely cost conscious.
  7. If you don’t fully understand what you are purchasing.

Final Thoughts:

I am not a fan of generalizations when it comes to financial planning or investments since everyone’s situation is unique.  I often find people have polar opinions on annuities and thus generalize them as all good or all bad.  I’ve been working as a financial planner for many years and have found some great instances to utilize annuities and some situations I had wished my clients had avoided acquiring them prior to us meeting.  In every case you will be best served sifting out the noise and working with someone you trust to help analyze your individual needs to determine what solutions work best.

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Andrew Rosen

In his role as Financial Planner, Andrew forges lifelong relationships with clients.  He coaches them through all stages of life and guides them to better achieve their life goals.  For more information about Andrew or the other firm partners, Kyle Hill and David Levy, click the link below.

Find out more about Andrew Rosen, CFP®, CEP®
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