By Fredrick P. Niemann, Esq. a NJ Elder Abuse and Financial Exploitation Attorney
What are the types of annuities you should be careful of?
A fixed annuity is a deferred annuity that grows by interest alone. Here, the issuing insurance company offers the annuitant a guaranteed rate of return over the life of the annuity. However, many fixed annuities do not have a fixed rate of return for the entire life of the contract, but rather a guaranteed minimum rate or “teaser rate” for a short duration in order to attract more consumers. A typical fixed annuity for example, might offer the annuitant 3% interest over 15 years – in other words, for the investment to appreciate 3%, the original amount invested in the annuity must be left undisturbed for the entire 15 years or harsh surrender charges are imposed. In addition, these annuities assess yearly maintenance fees, early surrender fees, and other creative “administrative” fees imposed by insurance companies to reduce the amount actually received by the annuitant when the annuitant matures.
A variable annuity is basically a tax-deferred investment vehicle that comes with some sort of insurance contract. However, gains in variable annuities, once distributed, are taxed as ordinary income tax rates, which can be as high as 35%. For most investors, the ordinary income tax rate is substantially higher than the maximum 15% capital gains tax rates assessed on long-term mutual fund investments and dividend income. The tax difference between ordinary income and capital gains tax rates can easily eat up the advantage of the annuity’s tax-free compounding.
Variable annuities are notorious for the fees they charge. Indeed, the average annual expense on variable annuity sub-account currently stands at 2.3%. The average mutual fund, on the other hand, charges just 1.44%. Unfortunately, variable annuity fees do not stop there. Many variable annuities also have loads on their sub-accounts, surrender charges for selling within, for example, seven years and annual contract charges.
Equity Indexed Annuity
Equity-indexed annuities are annuity contracts tied to a stock index provide a minimum rate of return–typically 3% that is guaranteed by an insurance company, but after fees are paid, the guaranteed rate is usually much less than the risk-free rate of return guaranteed by U.S. Treasury securities with the amount invested and often without compounding.
With an equity-indexed annuity the insurance company invests in a mix of bonds and stock options designed to give a targeted participation rate (explained below) on the return of a particular index e.g. the S&P 500 index. While the purchaser has no choice in the investment itself, he or she is able to participate, to a very limited extent, in stock market gains during a rising market. If stocks fall, then the insurance company guarantees a minimum return. Because of that guarantee, the equity-index annuity has less downward volatility than the variable annuity.
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