By Patrick Carney, CFP®
Unfortunately, it is not uncommon to meet prospective clients who attended an “informational” seminar, got a nice steak dinner, and ultimately purchased an annuity that may cost them thousands of dollars over the years. For example, a typical variable annuity has fees of 2% including internal fund expenses whereas low cost mutual funds’ are often under 0.5%. If you invested $100,000 in an annuity with costs of 2% per year for 10 years, you would end up with roughly $20,000 less than had you invested in a mutual fund with costs of 0.5% a year. Few people realize that “free” dinner could end up becoming the most expensive meal they’ve ever eaten. 
One could argue that variable annuities have one of the worst reputations of any financial product. That reputation has largely been earned by the sometimes ethically questionable sales practices of the people who sell them. A popular saying in the financial services industry is “annuities are sold, not bought”.
You might be shocked to learn that annuities often pay higher commissions than many other financial products. Furthermore, the amount that the salesperson receives is almost impossible to determine, in part because you never “see” some of it go out of your account. If you put on your green accountant’s shade and read through the big thick document you got when you bought your annuity, you might be able to add up the total costs. What you’ll find is that between insurance, “expenses”, and investment costs, you may be paying from 2.2 – 2.6% a year. Depending upon which options you chose you may be paying much more. 
Much like a doctor that prescribes the same cure for all ailments, annuities are viewed by certain people in the financial services industry as the answer before truly understanding the client’s problem. Case in point, shortly after I turned 18, I walked into my parent’s bank to open a Roth IRA. The “advisor” at the bank tried to convince me to buy an annuity instead. This was a totally unsuitable recommendation given my goals at the time.
For the record, just because they’re often inappropriately positioned does not mean that there’s never a justification for using annuities. As we get into the mechanics of how annuities work, you’ll see that some annuities may be appropriate for clients in certain circumstances.
How do variable annuities work?
A variable annuity is a combination of an insurance and investment product. For simplicity purposes here’s how it works: you deposit money into the annuity and that money gets invested into mutual funds (in an annuity they’re called separate accounts). The money in there grows tax deferred until you either take it out as a withdrawal or you annuitize it. Annuitizing (the insurance part of an annuity) means the insurance company is promising to provide you with a stream of income for the rest of your life in exchange for a lump sum of money. If you die the day after you annuitize, and you have chosen to receive a single life annuity, your family will receive nothing. By annuitizing you have traded the money you have in the annuity for guaranteed income for life. There are other options like a joint and survivor, period certain (a set payout over a number of years) or some combination of those options. Many people choose the single life option because it offers the highest guaranteed monthly income.
Let’s look at the two main options to get money out of an annuity:
Annuitization – Annuitizing is when the insurance company promises you a stream of guaranteed income in exchange for a lump sum payment that you make to them. If you choose to annuitize, each year a portion of the monthly cash flow is considered as gain and the remaining portion is considered as return of principal. This is determined in the tax code by something called the exclusion ratio. For example, if you have a $100,000 contract that was funded with an original investment of $60,000 and has a $40,000 gain, 40% (the gain) of your monthly income would be taxable and 60% (your initial deposit) could be excluded from being taxed because they are essentially giving back your own money. The portion of your payments that are gains are taxed as ordinary income. If you have an IRA annuity and you annuitize, all of your monthly payments will be taxable because you took a tax break when you made the deposit.
Withdrawal – If you choose not to annuitize and instead withdraw the money from the annuity, you will pay ordinary tax rates on any gains that you have. In comparison, mutual funds that are held outside of an annuity are taxed at the more favorable (0%, 15%, or 20%) long-term capital gains rates.
Additionally, when you pass away, any heirs who inherit the annuity (including your spouse) will pay ordinary income tax on all of your gains. Whereas with mutual funds, your heirs receive what’s called a “step-up” in your cost basis. That means when the heirs sell those funds, rather than having their cost determined by what you paid for the investment, their cost is determined by the value of the investment on the day that you died.
To summarize, the main drawbacks of an annuity are the costs, the tax treatment, and lack of flexibility. The primary benefits would be the ability to receive a guaranteed income stream and maybe the tax deferral.
What steps should you take to determine if you should get out of your annuity?
Step 1 — Determine if your annuity is an IRA or a non-qualified annuity
Non-Qualified — A non-qualified annuity is an annuity that’s purchased using non-retirement money. One of the key advantages is that it allows money to grow tax deferred. Taking money from a non-qualified annuity would mean you would have to treat any gain on the contract as ordinary income. Therefore with non-qualified annuities it’s important to weigh the tax consequences as well as the cost and benefits of the annuity.
Qualified/IRA Annuities — All IRAs grow tax deferred whether or not the money is in an annuity. Unless you’re using the IRA to buy an annuity for some of the insurance benefits, that’s a bit like wearing suspenders while you’re already wearing a belt. If you already own an IRA annuity, deciding whether to get out of it becomes a much more clear-cut choice because the factors that need to be analyzed are the costs and benefits. If you determine you don’t need any of the benefits that are associated with the contract, eliminating the cost of those benefits is as simple as transferring the IRA annuity to an IRA brokerage account. An IRA can be transferred from one IRA custodian to a new IRA custodian without needing to pay taxes on the transfer. There is one additional consideration and that is surrender charges. Some annuities, especially the variable type, often have surrender costs that can last for years. These costs reimburse the insurance company for the commission they paid to the salesperson. Surrender charges can be a key factor when deciding whether to keep an existing annuity. Keep in mind that these costs are often added to the annual expenses. So you are going to pay them either as a surrender cost or piecemeal each year you own the annuity until the surrender period expires.
Step 2 — Determine how much of a gain you actually have on the annuity
By determining how much of a gain you have, we can calculate how much the tax would be if you were to take the money out all in one year versus spreading it over multiple years. If you don’t actually have a gain or if you have a loss, deciding to leave the annuity suddenly becomes a much easier decision.
Step 3 — Determine what benefits you’d be foregoing by leaving the annuity
Some annuities may have attractive benefits that you don’t want to give up. These benefits are often quite complex and may vary widely from insurance company to insurance company. It’s important to evaluate what benefits you could potentially be walking away from. I have a client in his late 70s whose spouse would receive about $25,000 more than the current value of his annuity if he were to pass away. In his case we determined that was a valuable benefit that we didn’t want to give up. Unless you really sit down and analyze what you currently have, it’s impossible to know whether or not it’s worth moving.
Step 4 — Determine how this decision would interact with the rest of your income from this year
Any gains that you incur will all be added on top of any other income you have. So if you are still working, that would be an expensive tax year to withdraw the money. If you have recently started collecting social security, the withdrawal may end up making it so more of your social security is subject to tax than had you not taken the withdrawal. Depending on the size of the gain, the withdrawal could push you into the next tax bracket or risk triggering increased Medicare premiums because of crossing the IRMAA limits (income related monthly adjustment amount). All of these factors should be considerations for deciding if this would be the best year (or years) to redeem the annuity.
Step 5 — Determine what costs would be associated with leaving the annuity
One of the ways that insurance companies veil the cost of compensating the salesperson is through surrender charges. They are a schedule of fees that you’ll be charged if you withdraw your money before a certain time. Typically the salesperson will make somewhere between 6% and 7% upfront, but you won’t see an immediate decline in the value of your account. The insurance company that issues the annuity charges a higher ongoing expense called a Mortality and Expense Risk Charge or M&E. That charge will go partly towards the insurance component of your annuity but mostly towards reimbursing the insurance company for the commission they paid the person that sold you the annuity. These surrender charges allow the insurance company to avoid paying an upfront commission, only to have you leave the annuity before they’ve recovered that cost. A typical example of a surrender charge schedule might be 7% if you get out in the first or second year, 6% in the third year, 5% in the fourth year, 3% in the fifth year, 1% in the 6th year, and no charge in the seventh year and thereafter. You should determine the costs associated with leaving the annuity and whether those costs are worth incurring. Most annuities will give you the ability to redeem 10% of the contract value each year without penalty. So if an annuity has several years of surrender charges for withdrawing money, we will sometimes transfer out 10% per year over a number of years. 
Step 6 — If this isn’t the best year, determine if there are ways to lower your costs
There are some annuity companies that don’t have a layer of expenses that goes towards compensating a salesperson. They will often have total costs around 0.75% between insurance and investment costs. If you have a large gain that would be taxable if you were to withdraw the money, you may want to consider doing a Section 1035 exchange. A 1035 exchange is a transfer from one annuity to a different annuity without having the gain be subject to taxes when you switch. If you own an annuity that has a large gain and this isn’t the best year for you to incur the tax, a 1035 exchange could allow you to move from an annuity with high expenses to an annuity with lower expenses without incurring additional taxes.
The one takeaway that I hope you get from this is that annuities are complicated. While many of the broad themes are similar, almost no two annuity contracts are exactly alike. Each insurance company has unique rules, features, benefits, and costs. The person who sold you the annuity likely has an interest in either upgrading you to a new annuity and a new commission or recommending you keep the existing annuity. Deciding whether to keep your annuity or redeem it is something that you and an independent adviser should study very carefully. An independent adviser who doesn’t make their living selling financial products can help you work through these complex calculations.
 Assumes $100,000 grows at a 5% annual rate before fees and the applicable fees are deducted for each type of product.