Annuities 101: What You Need to Know | White Coat Investor (2024)

By Dr. James M. Dahle, WCI Founder

Lots of white coat investors wonder about annuities and whether they should own one, so today I'm going to tell you everything you need to know about annuities.

What Is an Annuity?

Annuities come in many different flavors. However, all of them are an insurance product with some sort of investment characteristic. At its most basic level, an annuity is a pension purchased from an insurance company. You give the company a lump sum, and in return, it pays you a guaranteed amount every month or year until you die. As an insurance product, the company generally pays a commission to the agent selling it to you. That agent often masquerades as a financial advisor, but, at least while selling you the annuity, is functioning as a salesperson and not an unbiased advisor.

The annuity is also backed by the insurance company. If the insurance company goes away, so does the annuity—except as provided for by state insurance guaranty organizations, which generally only protect a limited amount of an annuity's value. As a general rule, it is best to think of an annuity, at least the classic “buy a pension from an insurance company” annuity, as a way to spend your money, not as a way to invest it. The investment returns are generally not that good, but the purchaser finds the guarantees to be valuable.

Are Annuities Taxable?

The taxation of an annuity depends on whether it is placed inside or outside of a retirement account. If the annuity is inside a retirement account, there is no taxation due except on what comes out of the retirement account. Every dime that comes out of the retirement account is taxed at ordinary income tax rates. If an entire IRA is invested in an annuity (i.e. an Individual Retirement Annuity), the entire annuity payout takes the place of any Required Minimum Distribution that you are required to take at age 72. If the annuity is purchased inside a Roth IRA, the entire payout, like any withdrawal, is tax-free.

Outside of a retirement account, an annuity has its own unique taxation. In the classic “buy a pension from an insurance company” scenario, part of the monthly payout is interest, payable at ordinary income tax rates, and part is a tax-free return of your principal. The ratio of principal payout to total payout (principal plus interest) is the “exclusion ratio”. The exclusion ratio varies according to how much principal was used to purchase it, how long you have had it, and the interest rate on the annuity. Essentially, it is calculated to spread out the principal withdrawals over your remaining life expectancy.

Let's say you are expected to live 10 more years and you buy a $100,000 annuity that pays out 8% a year with $100,000. Essentially, your first ~12 years of payments (assuming you live that long) are tax-free. After that, payments are fully taxable at ordinary income tax rates.

If you withdraw money from an annuity (similar to a partial surrender of cash value life insurance), the interest comes out first. This is the opposite of cash value life insurance, where you take out the principal first in a partial surrender situation. In addition, an annuity is treated as a retirement account in that withdrawals prior to age 59 1/2 are also subject to a 10% penalty.

Growth inside of an annuity is tax-deferred, so you do not have to pay taxes on any interest, dividends, or capital gains until the money is withdrawn from the annuity. Remember that it takes many years of tax-deferred growth, especially if the underlying asset inside the annuity is relatively tax-efficient, to make up for paying ordinary income taxes on the gains rather than the lower qualified dividend/long-term capital gains rates.

If you inherit a non-qualified annuity, you can spread the withdrawals out over the rest of your life if you want, but you will still pay ordinary income tax rates on the gains when you do take them out. The sooner you want the money, the sooner you pay the taxes. If you also inherit an IRA, you can roll the annuity into the IRA if you like, but the money then becomes subject to inherited IRA rules. A qualified annuity basically follows inherited IRA rules.

The Problem with Annuities

The main issue I have with annuities is the same problem I have with whole life insurance—the way they're sold. They tend to be a financial product that is sold, not bought, and is often sold inappropriately. It is sold to people by making them afraid of higher returning but more volatile investments, like the stock market. It is also sold by pointing out all the cool “bells and whistles” added on to the annuity—all for a price.

Unfortunately, the bells and whistles are often NOT worth what you pay for them, and they make it very difficult to compare one annuity to another in a fair way. To make matters worse, annuity purchasers are often convinced to exchange from one product to another, generating a new commission for the agent but lowering their returns.

Commissions on annuities are generally in the 1-10% range. That might sound like a lot to those of us who are used to paying $5 for a trade at Vanguard or Fidelity, but it is dramatically less than what might be paid for whole life insurance, which is 50-110% of the first year's premium. The more complex the annuity, the higher the commission. For example, one type I don't like is a fixed index annuity which pays a commission of 6-8%. The more vanilla ones I suggest that you use if you want an annuity carry lower commissions such as:

Single Premium Immediate Annuity: 1-3%
Deferred Income Annuity: 2-4%
Multi-Year Guaranteed Annuity: 1-3%

Remember these commissions are built into the price of the annuity, they're not a separate charge. But you are paying them nonetheless. More complex annuities may have additional fees, such as surrender charges, mortality charges, administrative fees, and expense ratios. Read the fine print; it's really the most important print in the document.

Are Annuities a Good Investment? 4 Reasonable Uses

Let's go over a few ways in which a fully-informed person might use an annuity.

#1 Single Premium Immediate Annuity (SPIA)

This is the classic “buy a pension from an insurance company” annuity. You give the insurance company a lump sum of money, and in return, they start making monthly payments to you every month until you die. The payout is generally much higher than the classic “4% rule guideline” that people use to determine a reasonable withdrawal rate from their portfolio. The reasons the payout is higher are: 1) the payouts generally aren't adjusted upward with inflation each year and 2) there is nothing left for your heirs when you die. The guarantee provided by the insurance company is to pay you while you're alive and that's it.

There are SPIA-like products out there that will guarantee something will go to your heirs if you die soon, but they pay less than a true SPIA. Someone has to pay for that guarantee, and that someone is you. So what does a SPIA pay these days? In 2021, the best rates available were:

You can learn a lot about SPIAs by looking at that chart.

First, the key to really making out well with one is to live a long time. If you die young, it is by definition a terrible investment. If you live well past your life expectancy, the return is much better. It's the exact opposite of life insurance where the sooner you die the better the “return” on the investment. The data shows that annuitants live longer (and happier) than those without annuities, but nobody can really separate out the selection bias to determine whether correlation really is causation.

Second, you probably don't want to buy one too early. Even at age 50, you're only getting about 4% a year out of it. That's 4% not indexed to inflation, leaving nothing behind for your heirs. Chances are that you can live off 4% of that amount, index it to inflation as you go along for 30 or 40 years, and still leave three times the original amount to your heirs. There is some risk there, but it seems like you're giving up way too much for some guarantees with the annuity.

Third, the best time to really consider a SPIA seems to be in the 65- to 75-year-old range. You can spend well more than 4%, inflation has less time to decimate the real value of those payments, and you still have plenty of time to reap the benefit of guaranteed payments.

Finally, interest rates do have an effect on SPIA payouts. Our low-yield environment has made SPIA payouts lower than they used to be. However, the effect of interest rates on the payments is much more significant at younger ages, and the “mortality effects” (i.e. the fact that some annuitants die) have a much larger effect on payment size at older ages.

Who should consider a SPIA?

A SPIA is ideal for several kinds of people. The first is someone who does not want to take much risk with their investments. If you are only going to invest in CDs and bonds, the inherently low total return of a SPIA is no longer a reason to dislike it, because your total return isn't going to be any better. So you're basically getting the guarantees for free.

The second is someone who needs “permission to spend” the rest of their portfolio. As illogical as it is, most people seem to have trouble “spending principal” even though they know they are not immortal. It just feels better to spend income. Well, there really is no principal with a SPIA. It's all income. So you can spend it without a care in the world knowing there will be more next month. Plus, it gives you permission to spend from the rest of your portfolio knowing you will never really run out of money.

The third is someone who needs “permission to take risk” with the rest of their portfolio. If you know your basic expenses are covered by your guaranteed income sources (like the SPIA), then perhaps you could psychologically handle taking on more risk with the rest of your portfolio. You can invest less in bonds and more into stocks and real estate. The higher long-term returns you are likely to get with a more aggressive asset allocation can more than make up for the effects of inflation on the SPIA payments.

The fourth is someone who just doesn't have enough money. If you are 70 and sick of working but can't live on 4% of your portfolio, a SPIA allows you to spend a higher percentage of your nest egg. Now you can spend over 6% and not worry about running out of money. It'll cost your heirs, but most of them who really care about you would rather see you taken care of while you're alive than receive a larger inheritance after you die.

#2 Deferred Income Annuity (DIA)

In some ways, a SPIA is longevity insurance. It insures against the financial risk of you living a long time. A Deferred (sometimes called Delayed) Income Annuity is like a SPIA on steroids when it comes to the longevity insurance aspect. For example, let's say you are 60 years old and want to ensure that if you live into your 90s that you'll have at least $50,000 in income a year. You would need to spend $1 million on a SPIA. But if you buy a DIA instead, you could spend dramatically less. How much less? Let's take a look at 2021 rates.

Who should consider a DIA?

Appropriate DIA purchasers are similar to appropriate SPIA purchasers. They are either very worried about running out of money in their old age or really need permission to spend the rest of their portfolio. It's a much more “pure” product in that it is basically straight-forward longevity insurance, especially with a 20-30 year deferment period. It's a simple proposition: live a long time—get a lot of money for doing so.

Obviously, both of these products are lousy things to buy if you're not in good health. They may also be lousy purchases if you are someone who prefers to invest aggressively and can't stand the thought that the actual expected total return on these sorts of investments is in the low single digits. You need to really value the insurance aspect of the product or it will be a bad purchase for you.

A DIA can be combined with a SPIA to overcome one of the downsides of SPIAs. One of the big issues with a SPIA, especially one bought young (60 or under), is that in 20 or 30 years its real (after-inflation) payout may not be so hot due to the erosive effects of inflation. However, if you put a bunch of money into a SPIA and a little money into a DIA, you can start getting additional payments down the road when the SPIA payments aren't worth as much.

For example, let's consider a 60-year-old female with a portfolio of $2 million who decides to annuitize half the portfolio ($1 million total). However, let's say she decides to do it in the following way:

$700,000 into a SPIA
$100,000 into a 10-year DIA
$100,000 into a 20-year DIA
$100,000 into a 30-year DIA

If she did this, her nominal income for each decade of retirement would be as follows:

60s: $34,790
70s: $34,790 + $8,770 = $43,560
80s: $34,790 + $8,770 + $19,836 = $63,396
90s: $34,790 + $8,770 + $19,836 + $73,310 = $136,706

If she had just “SPIAed” the whole $1 million upfront, she would only be getting $49,700 a year. By using a combination of SPIAs and DIAs, she has somewhat protected herself against the ravages of inflation. Another alternative would be to leave that other $300,000 invested in stocks +/- bonds and buy a new SPIA every 10 years. On average, that approach would probably come out ahead (just like buying term life insurance and investing the difference comes out ahead of buying whole life insurance), but if you wanted the guarantees, this approach would provide it.

What is a QLAC?

A Qualified Longevity Annuity Contract (QLAC) is simply a DIA inside a retirement account. Since the passage of the Secure Act 2.0, one can buy a QLAC with up to $200,000 of retirement money, usually in an IRA. Since there is no income coming from this annuity, at least in the beginning, there is no income with which to make the equivalent of a Required Minimum Distribution (RMD). Thus, no RMDs are required. Some investors view this as the main advantage of QLACs, to lower their RMDs. However, since RMDs soon will not start until age 75, it will really take a long life for this advantage to be particularly useful. If you are charitably inclined, a Qualified Charitable Distribution (QCD) of up to $100,000 per year may be a better way to reduce the RMD. While DIAs have been around for a long-time, the ability to buy one with qualified, tax-deferred retirement dollars wasn't allowed until 2014. Secure Act 2.0 made them both more attractive (increased the amount you could buy to $200,000) and less attractive (RMDs not required until age 75 starting in 2033).

#3 Multi-Year Guaranteed Annuities (MYGAs)

MYGAs are the insurance industry's answer to the Certificates of Deposit (CDs) sold at banks. You pick the term. You put the money in. The insurance company pays you a guaranteed income as you go along and you get your principal back at the end. CDs are backed by the bank and the FDIC. MYGAs are backed by the insurance company and the state guaranty fund (generally considered inferior to the FDIC).

CD interest is paid out and taxed as you go along. MYGA interest is either paid out and taxed or left to compound tax-deferred inside the annuity. In addition, at the end of the term, a MYGA can be exchanged into another MYGA, further deferring taxation. Given the tax advantages of a MYGA, you would expect them to pay lower yields than a CD, right? But that's not always the case, especially for longer-term periods. Consider the following, as of 2021 during a period of historically low interest rates.

Yes, I know it is hard to get excited about anything in that table, especially in 2021 when the recent returns from growth stocks and cryptocurrency have been off the charts.

Who should use a MYGA?

But the point is that for money needed for any period longer than a couple of years that you're really not willing to risk principal with, you're probably better off with a MYGA than a CD. So anything you would use a CD for is a reasonable use for a MYGA. That means short-term savings where you cannot risk the loss of principal. If you can risk a little principal, you can buy some bonds. But don't expect bond yields these days to be much higher than what MYGAs are paying. In early 2021, the various Vanguard bond funds had the following yields:

#4 Low-Cost Variable Annuity

Variable annuities definitely fall on the more complex side of annuities, with the attendant higher commissions, other fees, and difficult-to-understand structures. However, there are two uses for variable annuities that are reasonable. Yet, both of them rely on finding a very low-cost variable annuity, something that has become much more difficult in recent years since Vanguard got out of the business. Nationwide buying Jefferson National (the next lowest cost option) didn't help, either.

The first use is to exchange the cash value of a whole life policy you never should have bought. If you are dramatically underwater on a whole life policy, rather than surrendering it and walking away, you can exchange the cash value (if there is any) into a variable annuity and then invest it. As the value grows back to the total of all premiums paid (the basis), that growth is tax-free. When the value equals the basis, you can surrender the annuity and walk away without owing any taxes on the growth since the surrender of the whole life policy. It's a little consolation and helps reduce the sting of the “stupid tax” you're paying for buying whole life insurance.

The second use is for a very tax-inefficient investment that you simply cannot fit into your retirement accounts. The classic example is a REIT fund, even a REIT index fund. It takes a long time (decades if ever) for the tax-deferred growth aspect of an annuity to overcome the fact that withdrawals are taxed at ordinary income tax rates rather than the lower qualified dividend/long-term capital gains tax rates. However, if the investment is very tax-inefficient, that crossover point comes a lot sooner. Maybe even in just a few years. So if you can keep the costs down, the tax savings could potentially make up for the additional costs and hassles of investing in a VA for a very tax-inefficient asset class.

Note that some ethical annuity agents and unbiased financial advisors feel that variable annuities should never be used. Maybe they're right, especially now that it is so hard to find a very low-cost variable annuity. The potential tax savings may not ever overcome the higher fees even if you hold the investment for decades. If you are considering this product, you really, really need to focus on the fees. The subaccount fees (the equivalent of expense ratios) can be as high as 5% in some variable annuities. Not 0.05%. Not even 0.5%. That's 5%. Good luck making money while paying fees like that.

Unreasonable Uses for Annuities

There are lots of people out there selling annuities inappropriately. They're salespeople trying to make commissions so they can send their kids, not yours, to college. Here are the most common types to avoid.

#1 Most Variable Annuities (VAs)

Let's face it, most variable annuities suck. The investments are terrible, and the fees are outrageous. You are simply better off buying low-cost, broadly diversified index funds in a taxable account. Plus, then you can tax-loss harvest, donate appreciated shares to charity, take advantage of the step-up in basis at death, and enjoy the lower qualified dividend/long-term capital gains tax rates.

#2 Fixed Index Annuities (FIA)

Knowing the popularity and usefulness of index funds, many in the insurance industry have tried to confuse you by selling products with the word “index” in it, such as “index universal life insurance” and “index annuities“. Fixed Index Annuities are fixed annuities, much like a SPIA or a DIA. However, instead of guaranteeing you a return, they make your return dependent on the performance of some type of index, usually the S&P 500. They sell these with the promise of stock-like returns but without any potential for loss.

The problem is that you have to give up so much on the return side to get the guarantee of no losses that the performance is usually similar to a regular old fixed annuity. It's not a way to participate in the market and still limit your downside. In fact, because of all of the complexity and additional costs and commissions, it often underperforms an old plain vanilla SPIA or DIA, especially in a down market. There are lots of tricks as to why this happens (the return doesn't include the dividends, participation rates are not 100%, caps, etc.), but all you need to know is that it does happen. If you want stock-like returns, go buy an index fund, not an indexed annuity.

#3 Complex Annuities

The nice thing about a straightforward SPIA, DIA, or MYGA is that they are commodities, just like gasoline. You buy them based on price. Gasoline that costs $2.10 per gallon is just as good as $2.25 per gallon gasoline. And a SPIA that pays 5.5% is better than a SPIA that pays 5.25%. But you can add so many bells and whistles to an annuity that it not only reduces the guaranteed income payout (the main reason you're buying it) but makes it impossible to compare it to its peers.

Examples of complexity include annuities that pay out until both spouses die, annuities that still leave something behind to your heirs, and annuities with basic and enhanced living benefit riders and death benefit riders. These are also sometimes called Guaranteed Minimum Accumulation, Withdrawal, or Benefit Riders. Each of these guarantees will cost you something, and most of them cost you a lot. More than they are worth. You can even buy a long-term care rider. These sorts of annuities are products designed to be sold (and for high commissions) and not bought. Avoid them.

The Bottom Line

There are some reasonable uses for annuities, primarily as a method of providing guaranteed income in retirement to protect against longevity. But just like with whole life insurance, this is a product that is easily sold inappropriately to unsuspecting investors.

What do you think? Do you have an annuity? Do you plan to buy one? Comment below!