In order to decide whether variable or fixed annuities are suitable investments for you, it is important to understand the nuances of both financial instruments.  Annuities can be compared to existing investing options, but they have an added perk of a death bonus paid out to your beneficiaries.

Fixed annuities

A fixed annuity is similar to a bank CD, except that it is obtained from an insurance company.  You put a set amount of money into the annuity, and the insurer pays you a set amount of interest for the agreed amount of time.  Unlike a bank CD, you will not be taxed on the interest of a fixed annuity until it is withdrawn.  However, if yours is a retirement annuity and if you withdraw the earnings before you reach 59.5 years of age, you will pay both an income tax and a penalty.  On top of this, insurers will often charge an early withdrawal fee if the money is taken out within the first seven to ten years of investing. 

Variable annuities

On the other hand, a variable annuity is like a mutual fund, where you invest in sub-accounts comprised of stocks and/or bonds.  You will often find variable annuities that are similar or even have the same name as mutual funds.  Nonetheless, they are not exactly the same thing.  A variable annuity has an extra set of insurance costs, meaning they are more expensive to run than a mutual fund.  Between the management fees and insurance charges, the cost of a variable annuity can easily climb to over two percent annually.

Financial differences

There is also a difference in the taxation of variable and fixed annuities.  As long as the money remains in the variable annuity, no taxes are charged.  However, the earnings are taxed like income when they are withdrawn, and again, you may be charged a penalty if you are younger than 59.5 when you withdraw them.  The twist is that even though the earnings are from long-term gains, they will be taxed at income rates, not long-term capital gain rates.  This means much more money gets paid out in taxes with variable annuities.

When it comes to safety, a fixed annuity compared to a variable one can be very similar to comparing a bank CD to a mutual fund.  A fixed annuity has less risk of principal, but does not offer very large gains. A variable annuity has higher risk and costs, but you have a potential to earn significantly more in profits.

Some investors are tempted to put IRA money into an annuity.  They only good reason to do this is to create an income stream; otherwise, you would be much safer investing in a CD or mutual fund.  To convert your IRA funds into an annuity effectively, you would want to buy a “payout” or “immediate” annuity that converts cash into guaranteed income.  However, this strategy may be better for those who are retired or approaching retirement.
Another factor to consider regarding investing in an annuity is the involved fees.  It should be noted that annuities usually carry a large commission, sometimes 20%, that is immediately paid to the seller of the instrument, thus reducing the earning power of your investment. If you are not careful, the high fees associated with an annuity can drain off a good portion of the profits you might have earned.  In the long run, many financial experts believe that it may be better to avoid investing in annuities, unless you have properly accounted for the cost-benefit analysis. 

For investors that already have annuity contracts or life insurance, there is a good chance that they have been approached by agents to “upgrade” the policy.  However, there may be some advantages and some disadvantages to making a change to your annuity. Quite often, if you wish to change the terms of the contract, more money is drained from your investment to pay additional commissions. Sometimes, the seller of the “upgrade” is merely “going back to the well.”

The available types of annuities

There are three variations of annuities: fixed, variable, or equity-indexed.  Fixed annuities have their earnings and payouts guaranteed.  In contrast, variable annuities base their earnings and payouts upon the investment options that you chose, and therefore, your profit fluctuates.  Variable annuities charge a variety of fees.  There may be fees for an early withdrawal penalty, risks that the insurance company takes, administrative costs, investing, and special features.

Equity-indexed annuities have features of both the variable and the fixed annuities.  They offer return rates between the two offerings, and they sit in the middle when it comes to risk. 

1035 exchange

The IRS will allow you to exchange your insurance contract for a new one without paying tax on the income and the gains.  These trades are called 1035 exchanges since they are governed by Section 1035 of the Internal Revenue Code.  While this can be a big benefit, there are some drawbacks. In a 1035 exchange, you must exchange your original contract for a new one – you cannot obtain a payout check and use it to purchase a new contract.  You also cannot exchange an annuity for a life insurance contract; it must be an exchange of an annuity for another annuity, or an insurance contract for an annuity.

There are several reasons why you would make a Section 1035 exchange.  Many annuities now offer bonus credits for each purchase payment that you pay.  There have also been innovative annuity features added to new annuities, giving you more options for investing and improved benefits.

However, it may not necessarily be in your best interest to make a Section 1035 exchange.  Many of the bonus offers are offset by higher charges from the insurance company.  Some charges expire on your current contract, but if you exchange for a new contract, these charges will be reapplied.  In addition, a new annuity may cost you more annually or in brokerage fees, and you might not always need the new features on an annuity. 

Understanding the fine print

There are several considerations if you decide to exchange your annuity.  Before you exchange, you need to know the total cost of the exchange and what the terms will mean to you.  In addition, you should fully understand the features that are offered and why you want them, as well as whether or not the features are worth the increased pricing.

In some cases, an exchange may simply be a strategy for your broker to earn a commission, and thus, you should enquire as to how much your broker will earn.  Ethically, they must advise you on the pros and cons of the exchange, and you should evaluate that information carefully.  You should also read all of the forms in detail before you sign on the dotted line, ensuring that you understand the consequences. 

Annuities are long-term investments, and a significant amount of growth they have experienced lately has been from exchanges.  Therefore, you want to ensure that the exchange benefits you in the long run.