One of the best things that my mom ever did for me as a young adult was start an investment strategy for me.
She wanted to get me started with investing so she set up some investment account with her financial advisor for my benefit.
At the time, I was young, clueless and completely indifferent.
But when I began my career as a financial advisor I finally became very interested in what investments I had. So I did some inquiring.
Turns out, my mom's financial advisor was purely an insurance agent and the “investment” I had was a fixed annuity paying 4.5%.
I remember thinking to myself, “Why does a 24 year-old need a fixed annuity?”
Turns out it was a very legitimate question.
What is an Annuity?
Annuities are another form of retirement savings, just like IRAs, 401(k)s, stocks, bonds, mutual funds and savings accounts. They're tax deferred, and come in a variety of types, with fixed, variable and equity indexed being the most common.
- Fixed Annuities act like a savings account. There is a certain amount deposited in the account, and that money earns interest. The interest is added to the value of the account and helps the account grow over time
- Variable Annuities act more like a mutual fund. The annuity holder selects the accounts they want to fund the annuity and puts a certain amount of money into each of those accounts. They make money based on how well those funds do.
- Equity Indexed Annuities act like a hybrid of fixed annuities and variable annuities. They offer downside protection by protecting your principal, but also limit your upside gains.
Annuities are thought of as being best for people who have large amounts of money, and who can afford to diversify their retirement portfolio. Typically, this describes older individuals that have accumulated some nice savings. But is that the only demographic that can benefit from an annuity?
Young People and Annuities
Whether a young person should purchase an annuity or not really depends on their financial situation and long-term goals.
For young people who have short term financial goals and not a lot of liquid assets, an annuity doesn't make any sense at all. Because of the penalties described below, a young person would be better off with a regular savings account for short term investing.
However, if a young person is financially stable and looking to have a diversify their retirement accounts, the equity index annuity or variable annuity could be a viable option. Notice I say “could be”, not “most definitely”. A fixed annuity, on the other hand, doesn't make sense at all.
Note: I would never choose an annuity over a Roth IRA or a 401k. The tax-free benefit of the Roth and the pre-tax benefit and convenience of the 401k make both of these first-stops. But if you already have these well-funded, an annuity can be a great place to stash more away for retirement.
Annuity Penalties – Read the Fine Print!
There are some penalties involved for using funds from an annuity, either for early withdrawal or withdrawal before age 59 ½.
Most annuities have a surrender period, ranging anywhere from 5 to 10 years. The penalty for withdrawing before the surrender period has passed varies with each annuity, so make sure you understand the surrender charges that are written into your contract.
The federal government also charges a 10% penalty if you withdraw any of the returns/profits of your annuity before the age of 59 ½.
If you plan to leave your money in the annuity until retirement age, then these penalties are not an issue. But still, it's something to be aware of: annuities aren't as flexible as other forms of retirement, that may let you borrow or withdraw for emergencies or in other special cases.
Why I Cashed Out My Annuity
The thought of only making 4.5% on my money was all I needed to cash out my annuity. I was too young and there was too much time on my side to be capped at such a low rate. (Ironically, many investors drool over making 4.5% nowadays).
When I called the insurance company to inform them of my decision, they warned me about the penalties that I would have to pay and how I may not ever get such a high rate.
It didn't matter. The decision was made.
I was taking the money and opening a Roth IRA.
Should You Buy An Annuity?
If you're young and don't mind some fluctuation in your investments, it's hard for me to make the case that an annuity makes sense. Especially now, since interest ratess are so much lower.
Now, if you absolutely hate the market and you love everything about the word “guaranteed”, then annuities might be right up your alley and we can help you obtain quotes for different annuity plans to best meet your needs. Just remember that annuities are a long-term investment, so educate yourself before investing in one.
The post Is an Annuity the Worst Investment a Young Person Can Make? appeared first on Good Financial Cents.
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