When Is an Annuity a Bad Idea? 8 Times the Answer Should Be No

An annuity is a contract with an insurance company. You hand over money, the company agrees to pay it back under a set of rules, and in exchange for that promise your money gets tied up for a stated number of years. For some people that trade is exactly right. For plenty of other people it is not, and they sign anyway.

I sell annuities. I also talk people out of them. The short version is that an annuity is a bad idea when you might need the money before the contract lets go of it, when it is the only money you have, when you are buying it for growth, or when somebody is in a hurry for you to sign. Here is the longer version.

First, What an Annuity Actually Is

There is no single product called an annuity. There is a category. An immediate annuity starts paying income right away. A deferred annuity grows first, then pays later or gets withdrawn. Inside the deferred group are multi year guaranteed annuities, which credit a set rate for a set term, and fixed indexed annuities, which credit interest tied to an index with a floor and a ceiling.

Variable annuities are a different animal. They hold market subaccounts, the account value can drop, and they are securities sold by registered representatives rather than under an insurance license alone. I work on the fixed side. The reason the category matters is that when someone says the word annuity, your first question should be which one.

When an Annuity Is a Bad Idea

1. 1. You might need the money before the surrender period ends. This is the big one. Most deferred annuities lock the money up for a term, and pulling out more than the contract allows during that window costs you a surrender charge. The charge usually declines year by year, and the schedule is printed in the contract. If your honest answer to "could I need a chunk of this in three years" is maybe, then the answer today is no.
2. 2. It would be your emergency fund. An annuity is not a savings account with a better rate. A roof, a transmission, a stretch between jobs. Those things show up on their own schedule, not yours. Build the cash you can reach on a Tuesday first, then talk about the money that is left over.
3. 3. You are under 59 1/2 and not finished using the money. The IRS generally applies an additional 10 percent tax on the taxable portion of an annuity withdrawal taken before age 59 1/2, with some exceptions. Stack that on top of a surrender charge and you are paying twice to get your own money back. There are younger people who should own an annuity. There are not many of them.
4. 4. You are buying one inside an IRA just for the tax deferral. IRA money is already tax deferred. A deferred annuity inside an IRA does not add a benefit you already have. There are real reasons to do it, like protecting principal or creating income you cannot outlive. Tax deferral is not one of them. If that is the headline of the pitch, ask for a better reason. The mechanics are in rolling a 401(k) into an annuity.
5. 5. Your plan needs growth, not protection. Fixed and fixed indexed annuities buy you a floor and charge for it in upside. Caps, participation rates and spreads all exist to pay for the downside protection. If the money has 20 years to run and your plan depends on market level returns, this is the wrong tool for that dollar. Here is how a fixed indexed annuity credits interest.
6. 6. Your guaranteed income already covers your bills. If Social Security and a pension already cover the monthly nut with room to spare, buying more guaranteed income is solving a problem you do not have. That money might be better left flexible for the things you actually want it for.
7. 7. It would be most of what you have. An annuity is backed by the claims paying ability of the company that issued it. That is not the same thing as FDIC insurance on a bank deposit. Concentration is its own risk, and an avoidable one. Spread the money across companies and across start dates instead of putting everything into one contract on one day.
8. 8. You are being rushed, or you cannot explain it back. The rate that expires Friday, the form that needs a signature today. A good contract will still be a good contract next week. And if you cannot explain in your own words what it does, what it costs and when you can get out, you are not ready to sign. That is not a knock on you. It means the explaining is not finished.

The Tax Details That Change the Math

Annuities get described as tax advantaged, and the deferral is real. The part that gets skipped is what happens on the way out.

• Gains come out as ordinary income. Growth inside an annuity is not taxed at long term capital gains rates when you withdraw it. It is taxed as ordinary income at whatever your rate is that year.
• Withdrawals from a non qualified annuity are generally gains first. If you bought the contract with money you had already paid tax on, the earnings come out ahead of your principal. The first dollars you take are the taxable ones.
• There is generally no step up in basis at death. Unlike an appreciated stock or a house, the deferred gain inside an annuity is generally taxable to whoever inherits it. If the plan is to leave this money to your kids, that detail belongs in the conversation up front.

I am an insurance agent, not a tax advisor. Run your own numbers with a CPA before you move a large amount of money. The point is that the tax story has two halves and most presentations only tell you the first one.

The Replacement Trap

If you already own an annuity, sooner or later somebody will suggest you trade it for a new one. A 1035 exchange lets you move money from one annuity into another without triggering tax on the gain, which makes the swap sound free. It is not.

Two things usually happen. The old contract may charge a surrender fee on the way out, and the new one starts a fresh surrender period on day one. You can be five years into a seven year commitment and land back at the start of a ten year one.

States require replacement disclosure paperwork for exactly this reason. Before you sign any of it, get three answers in writing. What am I giving up. What does the new contract do that the old one cannot. What does the person recommending it get paid on it. Sometimes a replacement really is the better deal. It is worth making someone prove it.

How to Pressure Test an Annuity Before You Sign

1. 1. Say the job out loud in one sentence. "This money is for income starting at 67" is a job. "It pays better than the bank" is not a job, it is a feature.
2. 2. Get the surrender schedule year by year. Not the length of it. The actual percentage for each year, on paper.
3. 3. Find the free withdrawal provision. How much you can take out each year without a charge, when it starts, and whether unused amounts carry over.
4. 4. Ask for every fee in writing. Rider charges, administrative fees, anything that comes off the account value each year. If there are none, get that in writing too.
5. 5. Separate what is guaranteed from what is illustrated. Guaranteed numbers live in the contract. Projected numbers are a picture of one possible future. Ask which column you are looking at.
6. 6. Confirm whether it is qualified or non qualified money. That single fact drives how every future withdrawal gets taxed.
7. 7. Ask which companies the agent compared and why this one won. An independent agent can set several contracts side by side. A captive agent can show you one company's answer. Neither is automatically wrong, but you should know which conversation you are in. More in the questions to ask before you buy.
8. 8. Use the free look period. State law gives you a window after delivery to cancel and get your money back under the terms printed at the front. Read the contract inside that window, not after it.

So When Does an Annuity Make Sense?

None of this means annuities are a scam. They do a job almost nothing else does, which is turn a pile of money into a payment that keeps showing up. That is worth something to the right person.

• The money is already earmarked as long term. You were not going to touch it anyway, and the lockup is a cost you can genuinely absorb.
• You want a floor under part of your retirement money. Not all of it. The part that cannot afford a bad year right before you need it.
• You want income you cannot outlive. This is the one thing an insurance company can promise that a brokerage account cannot.
• You have cash, you have coverage, and this is the next layer. Emergency fund funded, life insurance in place, and now you are deciding what the safe money should do.

If you are weighing one against a bank product, the tradeoffs are laid out in annuity versus CD.

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