Early nest egg: Say no to annuities

If you're still building up your retirement, steer clear of annuities. They have a function, but not quite yet, says Walter Updegrave.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I'm 44, and after maxing out my 401(k) and Roth IRA, I still have about $400 a month I'd like to invest outside these accounts for early retirement. Would you suggest I invest this money in an annuity? - Angie Tyrie, Hinton, West Virginia

Answer: The short answer is no, I wouldn't recommend you invest your extra savings in an annuity. Although I do believe a type of annuity known as an immediate, or payout, annuity can in certain circumstances play a valid role in a retiree's portfolio (for details, click here), for reasons I'll get into shortly, I don't think annuities are a particularly good way to build a retirement nest egg, particularly if you plan on tapping that money for early retirement.

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I should add, though, that you'll get a very different answer from people who sell annuities. They typically portray annuities - and especially variable annuities, which allow you to invest in mutual fund-like portfolios - as an excellent place to stash money once you've maxed out your 401(k), IRA and similar plans.

Indeed, based on the emails I get from individual investors, it's clear that some "advisers" also apparently steer people who haven't contributed all they can to 401(k)s and the like into annuities, a practice that, in my mind at least, can border on financial malpractice.

One selling point is the old standby that the money you invest in a variable annuity (which is the type most often pitched to someone in your position) grows without the drag of taxes until you withdraw the funds. But there's a new sales mantra from the annuity industry these days.

Today, the "killer app," so to speak, goes by the name "living benefits." Essentially, this refers to various riders and options you can tack onto the annuity. The one often pitched to someone your age is the "guaranteed minimum income benefit," a feature that promises you'll receive a certain amount of income in the future even if the investments within the annuity perform abysmally.

Another type of living benefit, geared more toward people in or closer to retirement, is the "guaranteed withdrawal benefit for life," which assures that you'll be able to withdraw a given amount of money as long as you live. But as tantalizing as all these features may seem, I don't think an annuity makes sense for someone like yourself who is still accumulating money for a retirement nest egg.

One reason is that most annuities come with onerous fees. In the case of variable annuities, there are several layers: an annual insurance charge that can run 1.25 percent or more; the annual investment management fees, which range anywhere from 0.5 percent to more than 2 percent; and, the fees for the various riders, which can add another 0.6 percent or more. Add them up, and you can be paying between 2 percent and 3 percent a year, if not more.

The fee extravaganza doesn't stop there. Most annuities also have "surrender fees" that can dock you 6 percent to 10 percent (and in some cases much more) if you decide to withdraw your money soon after investing it.

Unfortunately, many people who end up in annuities - or at the receiving end of a sales spiel about them - don't realize just how expensive they can be, which is why in a recent Long View column I recommended a simple form for disclosing the various charges. These fees alone are enough to make most annuities a lousy bet.

And, as I've written before, I don't think the highly marketed living benefits (which, by the way, are also used as a rationale to induce people to invest in a tax-deferred variable annuity within an already tax-deferred IRA) are worthwhile when you understand what you're actually getting and what you're paying for them. (For more on that issue, click here and here.)

But even if you manage to get around the fee hurdle - and, in fairness, I should note that there are some annuity providers who charge much less than the industry averages - I still don't think annuities are a good choice for someone like you.

Why? Well, one reason is the way your gains are taxed when you withdraw them. You pay ordinary income tax on investment earnings regardless of whether those earnings are interest income, dividends, short- or long-term capital gains. If you're investing for growth - as someone your age should be - you'll likely have the bulk of your money in investment options within the annuity that generate long-term capital gains.

But instead of paying tax on those gains at the long-term capital gains rate, which maxes out at 15 percent - as you would in a mutual fund held in a taxable account - with an annuity you pay tax at ordinary income rates that can go as high as 35 percent.

And if you withdraw your money before age 59 1/2, you'll not only have to pay ordinary income taxes on your gains, but you may also face a 10 percent IRS early withdrawal penalty. (This is separate from any surrender fee the annuity provider might charge.)

So given the fees and the way your gains are taxed, I don't find annuities a very appealing investment for someone looking to build a retirement nest egg. Throw in the possibility of a 10 percent early-withdrawal hit, and I think the case for them is even more underwhelming if you think you'll retire early.

So where should you put your extra savings? My suggestion would be a tax-efficient investment like a tax-managed mutual fund or a broadly diversified index fund that generates most of its gains in the form of share-price appreciation.

Until you sell, you'll pay no tax on the rising share value. And as long as you hold this investment longer than a year, any gain you realize from the appreciation in the value of your shares will be taxed at the long-term capital gains rate, as opposed to ordinary income rates with the annuity. (For more on how tax-managed and index funds help keep your tax bill down, click here.)

To sum up, I think you can do a lot better than an annuity with your $400 a month. At some point after you're actually retired, you may want to consider investing some of your money in an immediate annuity to assure yourself an income you won't outlive.

But in the meantime, if someone wants to sell you an annuity, just say no.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.