Welcome to EWA’s FinLyt podcast. EWA is a fee only RIA based at Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you.
And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. Welcome, everybody, to today’s FinLyt episode. We’re going to be talking about annuities.
I think annuities have a good part in some financial plans. But over the industry in general, it’s almost like an epidemic where they’re oversold high commissions and promise a lot of upside, but really hurt a lot of consumers, so today we’re going to do a deep dive.
Jamison and I are going to do a deep dive on when is an annuity a good option, how does it fit, and then what to look out for because I’d say over 90% of annuities will hurt you, not help you. So let’s get rolling.
Matt, let’s just start with what’s an annuity, what’s it used for? Yeah, so just by definition, if you think about like a insurance company, it’s the opposite of life insurance. So if you think about life insurance, protects somebody, a loved one, child, a spouse, maybe your entire family from dying too soon.
So if you think about, if you’re in the accumulation stage and you haven’t accumulated enough assets to protect your family or your kids are still in your roof and you’re planning on funding their college or retirement, et cetera, life insurance policy will protect those future earnings.
An annuity does the opposite. It’s for the distribution stage, so when someone’s older, you essentially are handing a lump sum of money to a insurance company and in return, they’re promising to pay you a paycheck until you die.
And then you can pay them back. can put a spouse on the annuity, where if you die, then it goes to your spouse until they die. But it’s the exact opposite of life insurance. Life insurance protects against mortality risk, against dying too quickly.
And annuity protects you against living too long, essentially. So you’ll never run out of money with an annuity if you purchase one. So just by definition, an annuity is meant for someone in the distribution stage or in that we love the analogy of Mount Everest.
There’s the climbing stage. You’re accumulating assets to get at the top. Once you’re at the top, there’s the most dangerous part, which is the getting down stage. And that’s where an annuity is a fit.
However, we see annuities mostly sold to someone in the accumulation stage, which is most of the time a very bad mistake. I think it’s important to note that this is a contract with a life insurance company.
And so then we mentioned this in past podcasts. Life insurance is also the same thing. oversold bad reputation and this kind of ties right along with it. So let’s dive into, we’ve seen some questionable annuity placements in our time.
So let’s look at, yeah, let’s just dive into why these have such a bad reputation. So the first thing, there’s very high commissions normally, generally not all news, but generally there’s very high commissions paid when these are sold.
So the agent that sells it is getting compensated very heavily. There’s regulations based on how much of your balance sheet legally can go into annuity because of this, but it still can be a pretty astronomical amount.
So because of this, they’re oversold, they’re pitched and pushed by these big companies because that is just fundamentally their business model of selling these products. That’s how they make money. And so a lot of times these look really good.
It’s like if you had like, if you had like an old car from like the 1950s and it got like the outside got remodeled and repainted and look like this like awesome sports car, but then you like lifted up the hood and like the engine was like, had like 500 ,000 miles from the 1950s.
Like looks really shiny and cool on the outside, but then when you like look on the inside, it’s like not what it looks like. It’s not so good. Yeah. And so that’s generally what a lot of annuities we see look like they’re sold.
They look really well, they look really good when they’re being sold, but then when you like take a deep dive, they’re not so good. So let’s talk about real quick, let’s talk about the pitch that we hear often.
So we’re going to talk about three types of annuities today. We’re going to talk about income annuities like fixed income annuities. These are in our belief the best and where we’ve seen really good planning can be for very select clients can be put into place with income annuities.
There’s a huge fad right now for index annuities. Index annuities, I’m going to use the term politely. A lot of them can be very scam -ish just with how they’re sold. And then the third type of annuity is a variable annuity as well.
We’re going to address all three of these. So why don’t we talk about the fixed annuity first? So, James, just give us a general breakdown on the fixed annuity. These are potentially the good type of annuities.
So just let me just give a quick example. There used to be, let’s just rewind 50 years. If you were a retiree, you really had like a three -legged stool to support your retirement. First and foremost, you had a pension from your company.
Most companies had a pension, worked similar to an annuity. It pays you a paycheck until you die or until your spouse dies as well. The second stool is you had a strong Social Security paycheck, typically.
And then the third would be your personal savings. Now, fast forward to today’s day and age, someone retiring most likely doesn’t have a pension, does have Social Security, but most of the pressure on the retirement is going to be their personal investments and savings.
At some point, if someone’s living off of, let’s say, they’re retired and they’re living off of $200 ,000 a year, and their only guaranteed income is social security between them and their spouse, let’s say, it’s a net $50 ,000 a year between the two, that’s $150 ,000 a year gap.
So if they have a couple million dollars saved in investments and they want to meet their obligatory needs, let’s say they want to spend $200 ,000 a year, $80 ,000 of that has to be spent, that we’re talking about a grocery as utilities, housing payments, et cetera.
And 50 of that’s coming from social security. Someone may want to purchase a fixed income annuity to give them that extra $30 ,000 a year, so they don’t have to worry about the stock market going up and down to meet their needs.
So in general, if someone’s in this situation as $3 million, we may see 10% of that going into income annuity, maybe $300 ,000, that then spits out in income, and that just allows the remaining, the $2 .7 million of investments to then be invested, strategically diversified inequities to keep up with inflation, et cetera.
So talk about how that works. So if you were to purchase a fixed income annuity from a reputable insurance company, what kind of company would you want to look at? Let’s talk about the state guarantees, and let’s talk about what options someone would want to select, especially if they’re married on that fixed income annuity.
Yeah, so a bunch of different riders, different things you could add to this, but just in general, what number one you want to get, just like whole life insurance, with a strong, triply -rated mutual company, this is gonna be, it can be similar to how life insurance is invested in their big general account portfolio, generally that’s a really safe investment, and they may give you, so again, a few back to what you already said, you give somebody, you use around numbers, $300 ,000 to the insurance company, they may say we’ll pay you $30 ,000.
for the rest of your life. That’s if they’re older. It’s usually about 6% or 7%. That’s probably going to spit out 20 ,000 a year for some of their 60s. So that would be an example. There’ll be a guaranteed or fixed minimum rate or return over that set period of time.
Typically, there’s less downside, meaning it’s guaranteed to come in versus if it’s invested in an investment account. It could fluctuate all the time. So you’re going to get much less upside in the growth, but there’s less downside.
We fundamentally believe this is not a thing for accumulation. So don’t buy this and then be 20 years away from retirement because you’re just missing out on rate returns in the stock market. Another thing, a lot of these fixed annuities have to do with interest rates.
And so the last five years or so, interest rates have been really low, which is making these less attractive. Interest rates have gone up. They’re a little bit more attractive. There are a lot of things to consider when you’re buying one of these.
And so really the only time that we think these make sense is exactly what you said. So guaranteed income for… for somebody in retirement? Yeah, so someone’s leading up to retirement, like, let’s say, within 10 years, and someone wants to secure some guaranteed income.
And there’s something called an immediate income annuity, and then a DEA, deferred income annuity. And both of these can be appropriate for someone close to the top amount everist, or already on the top, and looking to safely distribute assets.
But again, we would say, typically, 10% of liquid net worth would be the most that we want to see go into this type of annuity. But the important part of this is this would serve as part of a bond allocation, typically, because we like to see seven years’ worth of distribution.
So if someone has $200 ,000 a year of income need in retirement, and $80 ,000 is now secured through annuity, and so secured at least a $120 ,000 gap, and so we want to see seven years, which would be $840 ,000 of that $2 .7 million in that example.
So about a third of the portfolio will still be safe, and then 2 thirds would allow them to then be diversified into long -term equities to keep up with inflation. So with that being said, let’s just use the example.
You’re in your mid to late 60s. You give an insurance company. And so just a couple of quick hits on the type of insurance company. You typically want to see a mutual, triple A rated insurance company.
So there’s five really, really good ones I can think of. First of all, each state is going to back up these annuities. Like if that company goes bankrupt, typically most states will also step in. If the company goes bankrupt or gets bought out, the state will back up the guarantees of the annuity up to like a $300 ,000 purchase, for example, in Pennsylvania.
And so literally, even if the insurance company was bad, the state will step in and continue the payments until the annuitant beneficiary dies. So with that being said, the other thing to look out for on top of being a $300 ,000 purchase, is that you’re a reputable company is you want to have a company that has a solid block of business that’s diversified between life insurance and annuities.
If you think about if a company, if 90% of their business is annuities, and then doctors figure out how people can live like 20 or 30 years longer. Which is happening. Which is happening, right? That company then has a 20 or 30 year obligation, miscalculation on their books and they’re probably going to go under.
However, if that same company instead of having 90% annuities has 50% of their book, your revenue is life insurance, the other 50% is annuities. If people, if they grossly miscalculate annuities and people live 20 years longer than expected, they’re going to lose a ton of money on those annuities.
But they’re going to make up for that with their life insurance because they were expecting to pay out these life insurance, death benefits, and instead they get to keep that money invested for those same 20 years that people outlived.
their expectation on the annuity side. So as long as you’re purchasing an annuity from a company that has a diversified book of business between life insurance on one side and annuities on the other side, you want to look out because that’s going to protect you as the consumer, especially if you’re going above what the state will guarantee from that income annuity.
The other thing to look out for is looking for, you can name a joint annuitant. So for example, if you purchase one and you retire Jameson and you had a spouse, you could take a haircut and say, instead of giving me, I’m going to give you 300 ,000 if the company hypothetically was 20 ,000 a year until you die.
So first of all, it just realized that’s a 15 year break -even point. So if you live under 15 years, that company is keeping the difference. So really you have to live probably 20 plus years minimum.
So 15 years to get your money back but then factoring in inflation. We’re talking probably 20 plus years that you need to live. So adding a spouse, so if you die early at the continues to pay your spouse.
And then what I really like to see, because there’s not a huge difference between a payout if you just take it under your name versus if you take it with a spouse. I also like to add a 20 year guaranteed period certain on these contracts.
So for example, if you’re to give the company 300 ,000 and they were to give you, let’s say that 20 ,000 in return, but we put a 20 year guaranteed period certain and a spouse on that. And then let’s say now they’re only maybe 19 ,000 a year.
When no matter what, 20 years is gonna get paid. Even if you die in year one, your spouse dies in year two. There’s another 18 years that would go to kids. And so 20 years total times 19 ,000, that’s gonna be 380 ,000.
So you’re not only gonna get your $300 ,000 back in another 80 ,000, and it’s gonna go to your children as well. So with these type of news, we really like if you’re married, make it a joint, make it a, put a period certain on it as well, just to protect yourself.
You can’t, you know, social security and pensions. Typically when you pass those assets or those income streams then disappear. So we don’t want to put too much on the table that just disappears so you can protect that with the guaranteed period certain rider on these as well.
Anything else to add? I think we’ve hit the fix of newies in great detail. These can still be like miss sold if you put too much money into them. So again, we like these for distribution clients, people that are retired actively receiving income.
We also like to make sure that it’s only covering obligatory needs. There’s wants and needs in retirement. So if your Social Security doesn’t cover your needs, this could be purchased to cover the needs.
And then you have to then realize that this is another safe asset so that enables you to invest more aggressively with the rest of your liquid net worth. Anything else to add? No, I think it’s a good place to start too because that’s the basis of what an annuity you’re buying income.
And then these other types of annuities have kind of spun off of that, which is not for what they were intended to be built for, I guess. Absolutely. So the next one, indexed annuity. Like you said, this has kind of been like a fad lately.
And it’s pitched for accumulation. And then you can’t annuitize it. Let’s just say, let’s say you buy this thing when you’re in your 30s, the agent’s going to pitch it of like, you’re still participating.
And stock market upside, which we’ll talk about in a second. But then when you get into retirement, you could annuitize it if you wanted to, and then basically do what we said in the first thing. But these can be really complicated and extremely misleading, in my opinion.
So I’ve been on because some clients that had a previous advisor and some of these insurance contracts that are stuck, I’ve heard these pitches. They’re awful. Let’s go through a sample pitch. And this is going to be semi -a joke, but in reality, clients hear these pitches all the time.
So I’ll go through this. So this is legitimately, and none of this is true. I’m just saying this. This is what people hear out there. All right, so Mr. Client, Mr. and Mrs. Client, in today’s day and age, the stock market, it’s so uncertain.
They say these times are different, and you need to sleep well at night and make sure your money’s protected. So we have a solution to that. We have the upside of the S &P 500. If the S &P 500 goes up, you participate.
And if the S &P 500 goes down, like it did in 2008, it went down 37%. During COVID, it went down like crazy. And all this craziness, you’re protected, Mr. Client. Your money can’t go below zero. So I’ll check with the company.
But I mean, right now, there’s limits. They may only accept a million -dollar deposit. But we’re going to see if we can get an exception and see if you can put more than a million dollars in this. Ideally, we’d want to get all your money into this.
Why wouldn’t you? You have the S &P 500 in the upside. and you have no downside. That’s legitimately like a pitch that I’ve witnessed. And so then here’s a reality. So we had a client that put in, just call it $100 ,000, one of these things, these S &P 500 and next annuities.
And this was back in 2013. And they became our clients in around 2018. So they had this money stuck in here for five years. They put $100 ,000 in there. Now that S &P 500 during those five years was, it was like double digit, double digit returns.
The $100 ,000 when we took the money out, it was worth like $104 ,000. In this $100 ,000, this time period that we evaluated, the money, if it was truly tied to this S &P 500, it should have doubled.
So here’s a reality of how the contract read. The contract read like this. Every month, if the S &P 500 went up 1 .2%, they got that participation. If the S &P 500 went up 5%, they only got 1 .2%. If the S &P 500 went down, they were protected.
They did not get credit for the S &P 500 dividends. So the dividends were excluded. So first of all, dividends have made up how much of the S &P 500 is average just north of 9% over the last 100 years.
If you didn’t participate in dividends of the S &P 500, that makes up for over, I believe, a third of the return. Yeah, I have it right here, actually. It listed out. So 2021, the S &P 500 returned 23 .89%.
Dividends were 1 .3% of that. 2020, 18%. Dividends one and a half. 2019, 31 .5%. Dividends 1 .8%. So it’s basically about 2% a year of the return is from dividends. But when you reinvest those, I read an article.
It’s about a third of, a little over a third of your return and the S &P 500 over the last 100 years has come from dividends. So right off the bat, the insurance company’s saying, well, you don’t get credit for dividends.
So they’re taking what historically has done 9% a year and they’re guaranteeing you only get 6% right off the bat. So that’s problem number one. Huge issue, typically never disclosed. It’s just S &P 500 returns.
Well, a third of your returns are- Pop the hood up. Pop the hood up and suddenly, okay, we’ve got issues. This isn’t a brand new car. This is like a really old car. The problem number two is, does the S &P 500 go up just magically slowly 1 .2% per month?
No, some days it goes up. It averages a 1% oscillation basically on a daily basis. We can pull the statistics for that. But the reality is, with that cap of 12%, I mean, you had another client, then we had to get these out.
So, 2021 S &P 500 returns were 23 .89%, less the dividends, less the cap of 12. So if you were in this type of product, you would have missed 10 .58% of your return. 2020 S &P 500 return 18 .4, rip the dividends out 1 .58, your cap at 12, so you just missed 4 .8% returns.
2019 S &P 500 return 31 .49%, less the dividends of 1 .83, your cap at 12, so you just missed a 17 .66% return. All right, 2018 bad year for S &P 500 negative 4 .3, dividends are 2. Okay, you have a so that year you missed a drop of 4%.
But just compare that in the first three years you missed 10 .5, 4 .8, 17, so we missed 31% returns. And on the downside, we’ve avoided a 4% loss. So we’re still 27% behind. You compound this over 10, 20, 30 years.
I mean, there’s a reason if that investor put $100 ,000 in when they did the S &P 500 in the index fund, they’d be over $200 ,000. And there’s a reason they put $100 ,000 in this index annuity that’s tied to the S &P 500.
And when we pulled it out, it only had $104 ,000 in it. Yeah, this example of off the numbers that you just said, so nine years that this thing was in the annuity. First off, these are inside of IRAs, SEP IRAs.
I want to say maybe there was even one in their 401k plan. Everything was in this. But $200 ,000 was initially invested in 2013. After the surrender fee and everything, this client was, this was in 2021, it’s $252 ,000.
And so had that just been invested in the S &P 500 based on the numbers that we just talked about, be $430 ,000. Again, if it’s an IRA, you’re not paying capital gains taxes on it like it was. And how much actually was it?
250, so it’s like $200 ,000, almost $200 ,000. They missed 200 grand. Yeah. That’s crazy. Yeah, and then the wife had one too, so. And how old were these? These were doctors, right? Yeah, I guess they’re now in their 40s.
They would have been in like late 30s, mid to late 30s when these were sold. They haven’t even made it to base camp yet. No. Yeah. So these are, I mean, these are bad. That’s like, OK, let’s climb. I mean, basically what this is, this is like climbing Mount Everest and like, hey, what do we need?
We need food, we need water. Let’s put these bricks on our backpack. That’s basically what they did. Yeah. And then we’ll get into fees in a second. But then when you start digging into the fees too, that eats away at it.
But high level indexed annuities, not what they look like. They’re, what’s the analogy, the Trojan horse or something? It looks really nice, but then bad things come out. like it’s basically what it is.
It looks shiny, it’s not. I’ve never heard that before. Hopefully other people have. No, I think that’s right. All right, I’ll take your word for it. Just saying I’ll take your word for these index annuities are perfect.
I’m just kidding. They’re awful. Well, let’s look. We’ll get into a little bit more specifics here in a second, but then variable annuities. Why don’t you talk about what those are? Yeah, so variable annuities are, there’s certain scenarios where they can be good, but most of the time, they’re oversold.
So just off the bat, what should you expect a fixed annuity with a reputable triple A rate for an insurance company? It’s probably going to pay the person selling it, like 2% or 3% of the amount you’re putting in.
Just don’t, it’s a high commission. But if you’re doing that in the context of a financial plan, and that money is getting managed at 1%, it’s actually for the consumer. It’s a cheaper place than paying the advisor.
So an advisor who’s on AUM kind of have conflict of interest not to sell this right not to sell the good stuff Just want to point that out there as well. You know of an index annuity these things pay like Eight to ten percent they pay triple What the good, you know the income annuity is pay and there’s a reason for that I mean because we’re gonna talk about the fees and expenses I mean once you put a hundred thousand dollars in you only took a hundred four thousand out five years later your example 2013 The 2021 you put in how much?
200 ,000 200 ,000 there’s only 258 in there. Yeah, when there should have been like 450. Yeah Yeah, that money’s going somewhere. It’s going to the agent who sold it huge commission You’re 25 grand right off the bat and then it’s going to the insurance company who’s taking You know first of all the companies aren’t investing in this be 500.
There’s a reason for that They’re investing in like hedged very complex hedge strategies that guarantees they make a ton of money from these things so they have this figured out they The sales pitch and you know participate in the upside protect on the downside I mean it hits the emotions of everyone what everyone’s scared of but the ending result.
It’s a Very misleading. Yeah. Yeah, so if you understand everything you understand the fees And you still want to do this. I mean there there are some index annuities that are Cheapers might say every index annuity is bad.
I’m sure there are some examples where they could be a fit and could be good in General we evaluated them first of all we’ve never sold one We’ve evaluated Everyone we’ve evaluated we recommended it to get out, you know one surrender fees even sometimes with surrender fees because the break -even point Is is best just to pay it and sometimes after the expander fees expire Yeah, we we ran analysis for this client on take the surrender fee and Invest it and it still made more sense to take this with projecting it out What after the expenses and everything to pay the big surrender fee and then invest it versus leaving it in there They still because they I think they that that example they were paying all in like 3 .79%.
And all in, if they switched over because they had other assets, they were under 1%. So they basically cut their fees and rounded up to four to one. They cut their fees by 75%. So yeah, there’s a reason for that.
And they broke even within 12 months. Let’s look at variable annuities. Give us a high level review of that. Yeah, so variable annuity essentially is you’re giving your money to an insurance company.
It’s a bucket of money. It’s not like a promise. You could eventually annuitize it and make it a promise where then it’s tied to the market up and down. As sub accounts you can select, like a mutual fund.
So essentially, you’re purchasing some guarantees of not of the investments of the market value going up and down, but some guarantees that once you annuitize it, it’s tied to mortality rates, et cetera.
It’s still the same concept. You’re giving money to insurance companies. You have the option to annuitize it, where they pay you a paycheck for life, but it’s tied to the market up and down. So first of all, we really don’t like these, because if you’re going to talk about doing the guaranteed part of your plan where you’re planning against living too long, we want that actually guaranteed.
We don’t want that tied to the stock market. And then the second thing is some of these can have extremely high expenses involved with them, just because they’re called an annuity. The good applications for these is some states have asset protection for annuities.
So for example, if you’re a doctor, some states will give you like half a million dollars you can put in here. It’s tax deferred. You do pay taxes on the gains. If it’s a non -qualified annuity, your income rates are retirement.
So that’s a big reason we don’t like them, because if you just invest in stocks, you’d pay capital gain taxes, which could be almost half of what income taxes will be if you’re a high net worth high income doctor.
And the expenses are going to drag down your return if you’re in the accumulation stage. So where we see the good applications for variable annuities if you have a extremely low cost option. So for example, like Fidelity has an annuity where it’s like no commissions in.
You pay, I think, 10 basis points, 10 or 15 basis points to have it as an annuity. And whatever team you’re with, whatever their fee is, and that’s it. Versus an industry standard variable annuity, you’re probably paying 3% or 4%.
So you can get this for dirt cheap with the right company. Fidelity, Schwab, Vanguard, for example, would have very cheap variable annuities if you just want a wrapper around something to asset protect it.
And let’s dive in up like a real example that we’ll use that for is clients that have gotten oversold an annuity or a life insurance contract. And so we’re trying to unwind it. And you can do what’s called 1035 exchange.
So you can take the money in an annuity or a life insurance contract, tax -free rolled into another. insurance product. And so if we’ve seen, if you’re underwater, meaning if you’ve put in, let’s use this same example, if you put in 200 and it’s gone down, so this one obviously there is a floor, but if it had gone down to 150 and you pulled the money out and then you invested it into an investment account, the basis now is 150.
And so if you’re, if it grows back up to that 200, you’re paying capital gains taxes on that 50 ,000 of growth, well you could 1035 that into fidelity variable annuity really cheap, invested in the market, and then that rebound from 150 to 200 is tax -free because it’s inside of that annuity wrapper.
And then we could cash it out and put it in the investment account. Another thing to realize too is with an annuity, if it’s an unqualified annuity, if you’re under the age of 59 and a half, any gains above that 200 or get taxed income rates plus a 10% penalty if you’re under 59 and a half, but if you’re just pulling your basis out, so that in that example, the 150 ride at tax -free back up to the basis of 200, then rip it out.
There was no taxes, there’s no penalties, and now we can put it in a non -qualified direct index account where you’re paying capital gains, not income rates, and then have the flexibilities, no age restrictions, et cetera.
Now, what would you do if someone had a variable annuity inside of an IRA, and let’s say they’re 40 years old? Do we have to roll that into another annuity, or what’s the options there? No, you could just go IRA to IRA, because there’s no.
And leave the annuity behind. Yeah. That’s basically it’s an annuity, but then with an IRA wrapper on it. This is how complicated these things are. It’s like instead of a mutual fund, you’re in an annuity, these sub -accounts, but it’s inside of an IRA.
So you basically just sell out of that, and then move it over to an IRA. And that’s tax -free, penalty -free. If you’re going to IRA to IRA, so all the rules apply there. I’ve even seen, yeah, not to go on a tangent, I’ve even seen annuities inside of Roth IRAs, which is criminal.
We’re going to stay positive here, because we’re not going to go there. But yeah, don’t do that. So OK, so three examples. Let’s say someone’s 40 years old, has an annuity, it’s non -qualified, it’s underwater.
And that example, that person would want to 1035 that to another annuity to get the tax -free ride back up to basis. At that point, then consider moving out. If it’s not an asset protection concern, move it out to a regular non -qualified account, where then they have capital gain, rate treatment on the gains, plus flexibility without age restriction, et cetera.
If someone in the same example has a 40 -years -old, they put in 200, it’s not worth 250, what do we do now? And it’s a non -qualified annuity. Wait, so one more time if they were. If someone’s 40 -years -old, has 200 ,000 in non -qualified annuity, it hasn’t gone down, it’s gone up.
It’s not worth 250, what do we do now? You could, so if you sell it, you’re paying ordinary income rate plus the 10%. So that would be, I mean, this is where we’d have to do some analyzing in some more complex situation.
Maybe unwind, how would you say there are 40? Yeah. So, I mean, really the two options is you could, you know, essentially absorb that penalty now because you want flexibility and the ability to access all the money without penalties in the future.
So we’d pay 10% via $5 ,000 penalty to IRS plus the taxes on that $50 ,000. And let’s say someone’s in a 32% tax bracket, they’d pay another, I can’t do math right now, 16 ,000, right, of 32% 15 ,000.
Yeah, 16 ,000 of tax plus penalty, which would be $5 ,000. So out of that $50 ,000 of gains, they’d pay $21 ,000 right to the IRS. But then they’d have a net $229 ,000 that’s then flexible and can be invested in non -qualifying accounts.
So that would be one option. may not be the best option, depending on tax rates now and expected tax break in the future. The other options, we could just 1035 that into a low cost variable annuity. Probably cut the fees from 4% down to like, less than 1%.
And then just ride it. Ride it up until age 60, have that asset protection, and then start unwinding it during retirement. But that’s not gonna really hurt you if the cost of that, having that annuity, is only 10 basis points versus it being like 4%.
You could lose hundreds of thousands, not millions of dollars in fees. One other thing with the taxes too, so obviously capital gains taxes versus income rates are big difference, but most variable annuities don’t receive, so even if you just rode that out, like I’m gonna pass this on to my kids, there’s no step up in basis.
So if a non -qualified account with a basis of 100 ,000 that’s worth 200 ,000, you have 100 ,000 of growth, if you die, pass it to your daughter, she gets a step up in basis to 200 ,000. If it’s a stock.
If it’s a stock, yeah. But annuity, most cases, that doesn’t exist. She would get the 200 ,000, but she’d have to pay taxes still on the 100 ,000 dollar gain. So yeah, I mean, a non -qualified variable annuity is not something you wanna pass to a beneficiary versus like a regular non -qualified stock account would be a great place to pass money to kids.
One use case, I actually just did this with a client. He had one and he’s like 70 in retirement. It wasn’t huge, but there was a gain that we didn’t wanna take it out because we’re distributing now, and he’s coming down the mountain in distribution modes, we’re being aware of Medicare surcharges, tax bracket management, Roth conversions, all this stuff.
So we’re basically, we’re taking the annuity that had this gain that he’s never gonna use and he wanted some money to get a charity. So we re -read his whole estate plan and we made the annuity, we put the, we opened a donor advice fund, made the donor advice fund the beneficiary of the annuity.
So we brought it over into that fidelity. low cost variable annuity, we’re just gonna let it ride. And then when he dies, it’s gonna go right into that donor advice fund, no taxes. He doesn’t have to pay taxes versus if it goes to his kid, he pays taxes and then the charity gets it tax free.
Nice, that’s a good example. One other case, use case for variable annuities. If someone got oversold, whole life insurance. Generally, we are believers in whole life insurance. If you’re high income, let’s say over half a million dollars of income as a household and asset protection, lots of tax benefits and protection first, life insurance is life insurance with meant to have a death benefit.
But it’s a very tax efficient safe place to store money if the policies are structured correctly. However, a lot of agents, insurance agent debt, there will, we’ve seen oversell these contracts, right?
So generally, if someone is making $500 ,000, maybe 5% of their income, maybe they’re contributing $2 ,000 a month. Let’s say someone making $500 ,000 was sold to policy if they’re paying $6 ,000 a month.
So triple what we’d recommend, which we’ve seen happen, obviously. And now they’re in the midst of doing a financial plan. They’re like, what do we do with these? They’re underwater. We put in $200 ,000.
Cash out is worth $150. Well, one option would be you can 1035 a whole life insurance contract, the cash value, into a variable annuity. Now, if you just cash the thing out of the whole life policy and you put in $200 ,000 and it’s only worth $150 ,000, that $50 ,000 loss you’re going to take, and there’s no, you can’t carry that forward like a stock loss.
However, if you 1035 it into a low cost, no commission, variable annuity, the basis will transfer from a life insurance contract to annuity. So that $150 ,000 will transfer over. And then essentially, that client has a tax -free ride from $150 ,000 back up to the basis of $200 ,000.
They don’t have to pay taxes on that $50 ,000. And then once it reaches $200 ,000, then we can transfer it out to the taxable non -qualified account, where then it just gets capital gain treatment. So for someone unwinding a whole life insurance contract, typically a variable annuity is the best first place.
Because most people, if they have a whole life insurance contract that’s properly in place, it’s a lifetime tool and you don’t want to cancel it. So typically you’re canceling it. Someone cancel a whole life insurance product will be, because they’ve had a job loss or they were oversold.
And most likely they’re canceling it, because it’s underwater, what’s this doing? So then the best place for it to do would be with variable annuity to get some tax -free growth back up. But again, only a low cost, no commission, variable annuity, if they intend just to ride it back up the basis and then get it out.
Yeah, absolutely. Let’s, OK, I think we hit on most of these, but I put a list of main problems. We can. go through any of these we didn’t hit. But high level, they’re super complex and confusing, these contracts.
Most of the time the agent’s selling it, doesn’t even fully understand it. And general rule of thumb that I like to advise on is don’t invest in something you don’t understand. So hard to understand and complicated would be one problem.
Fees and expenses we talked about. So this is an example of the client that we talked about. This annuity had. This is an index annuity, just to be clear, right? Yeah, it’s an index annuity. So there was no, there’s no flat, like, advice, there can be an advisory fee.
Generally, there’s no flat fee for like an assets or management fee. So there’s number one, the mortality and expense cost. That’s just the insurance company saying, hey, we’re afraid you’re going to live too long.
So we have to take a fee out of this. It’s to protect us in case you live too long. And there’s an expense for us to have this annuity on the books. So we’re going to charge you how much? This one was 1 .33%.
And then there was the sub -account fee. So this would be the, you know, if you’re in a low cost ETF, that could be 10 basis points. 0 .1%. 0 .1. This sub -account was 0 .99, so about 1%. And so there’s that.
And then there was a death benefit rider on it, which was 0 .55%. And then there was income rider, which was 0 .92. And the all -in cost was 3 .79%. I have no comment. And they were in their 40s. Or maybe late 30s.
They’re accumulating still. Is this person in jail? That’s all it do? I would put him in jail. Yeah, so we’ve seen. All right, so let’s get to the point. So 3 .79%, that will ruin your chances of, because that’s coming out where the market’s up or down.
So just the reality is how these work. And plus these contracts will offer all these bonuses. You put the money in, we’ll give you a 10% bonus. Here’s how this actually works, right? So what someone has to understand if they’re purchasing the next annuity is typically there’s a couple of that.
There could be up to three, like three values, right? So you have your, what’s it called? Your annuitization value. Yeah, there’s a name for it. Yeah, go ahead. So it’s irrelevant, right? But basically there’s three different values.
And two of these three are basically fake, right? So there’s a death benefit value if you die before a certain point. We’ll just get life insurance. Don’t try to mix up all these tools. Secondly, there’s a annuity value.
And that’s like the annuitization value is fake until you annuitize it. And that’s where the bonus is like, if you come give us your money, we’re gonna give you a 10% bonus. That’s not on the market value.
Like if you rip that thing out the next year, that bonus doesn’t work off of the actual money, but you are gonna get a surrender charge. It’s gonna be extremely expensive. So what people have to realize is when they were talking all this like industry jargon, It’s not on your actual money, it’s on the annuitization value.
And most people that do index annuities, they don’t even annuitize the thing. So you have to realize, OK, if you put 100 ,000, you have a bonus, and it’s a guaranteed growth of 8% a year for the first 10 years, whatever it is, that’s on the annuitization value, which only is going to matter if you annuitize the thing, or if you start taking income.
And when they start giving you income, they’re going to cap you at only taking 4% or 5% a year. So we did some very detailed analysis showing, OK, if you do this, you get the bonus, you get that guaranteed growth of 8 years.
Let’s say you do end up taking the income when you’re 65 and you live till 95. Like, you’re ending return with all that guaranteed growth and all those bonuses. They’re ending return internally. It was like 2% or 3%.
It was the same as a CD. But with zero liquidity, because if you did this and you tried to pull the money out, You’re immediately if you put a hundred grand in there you’re only have like 90 ,000 there’s gonna be this huge surrender fee Typically the surrender fees if you take the whole thing out even later Because you’re limited to only being able to take it out So these these products like that the decks are totally stacked in favor of the insurance company agent selling it And once you’re in it’s it’s done.
It’s too late. Yeah, but sometimes you Do the contracts are illiquid. Yeah, you can’t get the money out Be very careful. Okay. Well, that was actually the second one is liquidity sometimes you you can actually never get the money out And so typically then there’s a big surrender fee and so we’ve talked about this in our on our episode on safe assets But what’s purpose is safe assets to have the money when the when everything else is kind of hitting the fan If you can’t get the money out then how safe is it?
It’s probably the riskiest thing you’ve done because you can’t get it. Yeah So liquidity is a concern limited investment options. So if you’re in these sub accounts, these are not the same as mutual funds or ETFs These are accounts that the inch generally Most cases these are accounts that the insurance company owns so that’s a Downside and then the tax inefficiency so the tech we already talked about this But ordinary income rates versus long -term capital gains if your income rates higher than your long -term capital gains rate, obviously that would hurt you And a lot of times these aren’t inflation adjusted And if they are you’re paying the fee for them along the way you’re paying one of those added costs to get If you ever new ties it then it grows with inflation.
So Inflation could eat away at these things as well Crazy crazy Well in closing, you know the annuities can be a really complicated landscape so recommend work with an advisor to understand it Educate empower yourself on how long -term markets work, you know put the deck in your favor the stock market is essentially a transfer of wealth from inpatient investors to patient investors.
So understand how it works. Position yourself in a financial plan so you don’t have to worry about stock market crashes. You have actual safe and liquid money available. And if you’re going to consider annuity, probably only should be doing so if you’re within 10 years of retirement of that climbing, now we’re descending stage.
And if you do so, in general, we’d recommend income annuities that are fixed with the AAA mutual insurance company or with the stock company as long as it’s under the state guarantees. Look at the company’s balance sheet.
What is their block of business? Do they have a strong mix of life insurance and annuity business? Protect yourself. And in general, steer clear of index annuities. And in general, variable annuities, case use them if asset protection, but do so with a low cost, non -commission type annuity with a reputable provider, like Fidelity, Schwab.
Vanguard, etc. But we welcome any questions from listeners and hopefully this was helpful. If you haven’t already, please hit the subscribe button and please give us a rating. That’s how we can have a more reach and reach our goals of financial literacy for the masses.
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