An Exception to the Annuity Rule

By Bob Moeller
WEAC Member Benefits

October 2002

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Achieving Financial Independence

As I promised in my June column, I am going to recommend an insurance company annuity product that is not a tax-sheltered annuity (TSA) product. This article is about after-tax annuity products, sometimes called single premium annuities, sometimes called variable annuities. Most of them are awful. Here’s the premise: You put after-tax money into an insurance company annuity. You can invest it in a fixed-interest product (fixed) or in stock funds (variable). You do not have to pay any taxes on your growth or gains until you take the money out. Doesn’t sound so bad, does it? But, there are serious negatives, such as:

1. If you take your money out before a certain number of years, you pay stiff withdrawal penalties.
   
2. When you take your money out, if your stock funds had capital gains, you get none of the long-term capital gain tax breaks. Any money taken out is taxed as regular income.
   
3. The typical annual fees charged against your account are over 2%. This means if your stock funds average 8% a year, you are giving one-fourth of the gain to the insurance company. If the market goes down, you are still giving over 2% of the value of your account to the insurance company each year.
   
4. If you take your money out before you are 59½, you pay a federal income tax penalty of 10%, in addition to regular income taxes on your gains.
   

All in all, I never recommend variable annuities.

But, the markets are down, and volatile. Many members are hesitant to invest a lot in stocks or stock mutual funds. Instead, they are piling up money in money market mutual funds or bank accounts. The two money market funds I regularly recommend (Vanguard and the NEA Insured Money Market Fund) are paying 1.52% and 2.75% as this is written. Banks are paying even less on money funds. Members are e-mailing and calling, asking if there is some safe way to earn more. And, more and more I am seeing ads from insurance companies or agents in the local paper advertising higher rates for fixed annuities.

Many of the low-cost mutual funds such as Vanguard and Fidelity own, or are affiliated with, a life insurance company. As you might expect, their annuity products are much more reasonable in terms of fees, etc. So, I did a little checking on fixed annuities. I wanted maximum flexibility with minimum fees and a good interest rate.

Here are the questions you need to ask:

1. Any up-front fees?
   
2. Any withdrawal penalties – and what is the schedule?
   
3. Any annual fees and how much?
   

Vanguard (1-800-6645733) looked like this:

• No up-front fees.
  
• $10,000 minimum.
  
• 5% rate guaranteed for five years.
  
• Could withdraw 10% of value each year with no penalty.
  
• If more is withdrawn, the penalty is 6% for year 1; 6% for year 2; 5%, 4%, and finally 3% for year 5.
  
• Annual fees – none
  
• Any withdrawal prior to age 59½ subject to 10% tax penalty.
  

Compared to most insurance companies, this isn’t bad, but I was not tempted.

Then, I checked out TIAA-CREF (1-800-223-1200). The product is Personal Annuity Select. If you are 59½ or close, this is a very good fixed annuity product. Even if you are younger, read the withdrawal rules very carefully, and you may decide this is much better than a money market mutual fund even though you pay a 10% tax penalty for early withdrawal.

The deal as of September 10, 2002:

• No fees.
  
• Minimum $250.
  
• 4.7% interest rate guaranteed until March 2003.
  
• Then can be a different rate (minimum 3%), but if you don’t like the rate, you can withdraw the money.
  
• Withdrawal terms: Your first withdrawal can be at any time with a minimum of $1,000. No fees, but regular income taxes on your earnings, plus a penalty if you are younger than 59½. The IRS considers money out to be first earnings and then your original principal. Your next withdrawal cannot occur for at least six months unless you withdraw the entire account (no penalty to do so).
  
• Thus, to earn this higher rate with no risk, you have to make sure you plan withdrawals carefully. Each six months or more you can withdraw without penalty. If rates go up, you will most likely get higher rates, because if you don’t, you’ll just withdraw everything and redeposit.
  

Note that even if you are younger than 59½, if you can abide by the six-month withdrawal restrictions, this may be a good replacement for a money market mutual fund. Even if you pay a 10% tax penalty because you are younger than 59½, your effective interest rate is still about 4.22% after the tax penalty.

Posted September 27, 2002