Indexed annuities are hybrid products that share some of the characteristics of both fixed and variable annuities. You invest your money in a annuity contract for a specific number of years, and your returns are based on the performance of the stock market. However, if the market performs poorly, you receive a return based on a fixed interest rate. The potential for high returns and the assurance of at least a minimal return make these insurance contracts attractive to many investors. Nevertheless, indexed annuities have several drawbacks to consider.
When you buy an indexed annuity, your returns are based on the performance of a market index rather than on the performance of a mutual fund or the market as a whole. Market indexes such as the S&P; 500, only track one type of security, so indexed annuities do not provide you with the kind of investment diversity that you get when you invest in a mutual fund. Furthermore, indexed annuities have participation rates that cap your returns. Depending on your contract's terms you may get a return that amounts to up to 80 or 90 percent of the actual return on the index, or you may get a flat rate of return if the index rises. Either way, you do not get the full benefit of market upswings.
Guaranteed Minimum Return
When you buy a fixed annuity, you earn a fixed rate of interest on your money and receive interest plus a return of the premium when the annuity contract ends. While indexed annuity contracts provide you with a guaranteed minimum return, you often end up getting less than you actually invested. Typically, the guaranteed minimum return amounts to an interest rate of 3 percent or less, but the insurer only pays that interest on 90 percent of your premium. When you redeem the contract you get back 90 percent or less of your principal, as well as up to 3 percent interest on that sum.
Indexed annuities have a lot of fees compared to other types of annuities. Indexed annuities often have term times that exceed 10 years and you have to pay penalty fees if you cash in your contract before the end of the term time. These fees often surpass 10 percent of your principal. And when you cash in the account you only get the higher of current value of the contract or the guaranteed minimum return, minus penalty fees. Consequently, if the index performs poorly, you end up with significantly less than you originally invested.
Indexed annuities provide you with the same tax-sheltered growth as retirement accounts. However, when you withdraw money from a retirement account funded with after-tax earnings, federal tax rules prohibit you from withdrawing your non-taxable principal before you have to tap your taxable earnings. On deferred annuities, you have to withdraw your earnings first because the Internal Revenue Service taxes annuity distributions using the last-in-first-out principal. If you access the funds before you reach the age of 59 1/2, you also pay a 10 percent federal tax penalty. Add together the taxes, the tax penalty and the annuity contract penalties, and it is possible to lose a significant sum of money when you invest in an indexed annuity.
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