“Why is it dumb to buy annuities? Fidelity has a plan that you can buy and trade stocks and money market funds within the annuity. With this plan you can escape capital gains. Why would this be dumb?” -Frank Cardinaux

First off, I doubt Fidelity has quite the plan you describe. When I called to ask, they couldn’t find it. At almost any brokerage house, you can set up an IRA or Keogh Plan (if you qualify) within which you can trade stocks . . . but that’s not an annuity.

Annuities do shelter your income and gains from tax until withdrawal, and that’s appealing, but:

  • There’s no telling what the tax code will be decades from now, but historically, long-term capital gains have been taxed only about half as heavily as ordinary income. And guess what: annuity income is fully taxed as ordinary income, even if it was produced from long-term capital gains. So annuities wind up converting what could be lightly taxed long-term capital gains into more heavily taxed ordinary income at withdrawal.
  • Annuities frequently entail sales charges and management fees, as well as a charge for a life insurance component that’s not terribly valuable. So you have a lot of drag on your performance.
  • Typically, it’s a hassle, at least, and expensive, at worst, to switch funds from one annuity to another, so you give up some control over your money when you buy an annuity.
  • Once money is in an annuity, there are restrictions on withdrawing it.

Most independent financial advisors agree: the purchase of variable annuities (the kind that are essentially tax-deferred stock mutual funds) rarely makes sense. But that doesn’t stop an army of eager sales people from selling many tens of billions of dollars worth each year. (Nor should it discourage you too much if you’ve already bought one. It may not be the greatest investment decision you ever made, but just saving the money in the first place is 80% of the game-you did a good thing.)

We all hate paying taxes so much that we often go to great lengths to find ways not to. In the Seventies, it was crazy tax shelters that had so many sales charges and fees, and so little economic justification, that much of the time you would lose 100 cents on the dollar trying to avoid paying 70 cents on the dollar in taxes. In the Nineties, it’s variable annuities. They’re not nearly as bad as many of those crazy tax shelters were. But they’re still not as good, for most people, as investing outside an annuity.

 

 

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