Why I Am Not a Fan of Most Annuities

First and foremost, annuities force investors to sacrifice higher returns for the perceived safety they offer. Variable and index-linked annuities, in particular, use complex formulas to calculate returns. Take, for example, an index-linked annuity that tracks the S&P 500. While you might receive the change in the index’s value, you miss out on the dividends that are paid out by the companies in the index. Over a long period of time, this loss of dividend income can have a significant negative impact on overall returns.

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Second, the high fees are a serious drag on performance. Most annuities I’ve encountered include investment management fees and mortality and expense charges that exceed 2% annually. To make matters worse, many of the annuities I’ve recently reviewed also impose surrender charges if the contract is less than six years old. These fees eat into the returns that investors might otherwise see, further diminishing the appeal of annuities compared to more straightforward investments.

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Third, the tax treatment of withdrawals is another downside to annuities. Instead of benefiting from the preferential tax rates applied to capital gains or qualified dividends—ranging from 0% to 20%—annuities subject you to ordinary income tax rates, which range from 10% to 37%. This taxation on withdrawals can make a significant difference in your overall retirement income, especially for those in higher tax brackets.

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Finally, one of the most glaring issues with annuities is the lack of a step-up in basis after death. When you pass away, investments in stocks, real estate, or other assets receive a step-up in basis, meaning your heirs are not burdened with taxes on the capital gains accumulated during your lifetime. Annuities, however, do not offer this advantage. Your beneficiaries may end up paying ordinary income tax on the annuity's gains, which can lead to a much higher tax bill than they would face with other types of inherited assets.

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Bearing in mind these factors, I believe more traditional portfolio strategies can provide greater flexibility, lower costs, and better after-tax returns than annuities. By constructing a portfolio of diversified investments tailored to a client's specific risk tolerance and financial goals, it is possible to achieve strong returns while minimizing taxes and fees. This, to me, is the more thoughtful and effective approach to retirement planning.

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