Annuity remorse. That may be the diagnosis if you regret purchasing a contract that you no longer want or that you think charges too much in fees. The cure could be costly if the annuity is in a taxable account. Cashing it out will automatically trigger a tax bill on all the earnings that have grown tax-deferred— in your top tax bracket. Plus, you could face a 10% early-withdrawal penalty if you’re under age 59½.
But there is a way to get out of the annuity without that costly side effect—a procedure called a “1035 exchange.” This lets you move from one annuity to another while still deferring the tax bill. Switching to a lower-cost annuity could save you thousands of dollars per year. (If your annuity is in an IRA, you can get out and avoid the tax bill without having to switch to another annuity if you keep the money in an IRA.)
“The annuity market has changed significantly,” says John Ohl, chief executive officer of Bay Colony Advisors, in Concord, Mass. “As lower-cost annuities come to the market, people who purchased annuities in the past are starting to do their homework and save a lot of money.” Before you switch annuities, compare fees, investing options, surrender charges, and any guarantees or other special perks that come with both the old annuity and ones you are considering.
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Many variable annuities charge more than 2% in annual fees, which can include annuity charges of 1.2% or more (called “mortality & expense” or “M&E” fees), plus investment fees often topping 1% per year for a limited menu of expensive mutual funds. That adds up to at least $6,000 in fees each year on a $300,000 annuity. “The price was usually so high that it wiped out the value of the tax deferral,” says Mitchell Caplan, chief executive officer of Jefferson National, which offers a lower-cost variable annuity through financial advisers.
The firm’s Monument Advisor annuity charges just $20 per month in annuity fees and offers more than 350 investment choices, including low-cost Vanguard funds. Financial advisers can manage the annuity’s mutual funds just like they would with other investments. “The annuity charges are much lower, and your quality investment options usually go up substantially,” says Jim Holtzman, a certified financial planner with Legend Financial, in Pittsburgh. New clients frequently come to him already owning expensive annuities, and he helps them switch to lower-cost versions.
Fidelity and Vanguard offer low-cost variable annuities directly to consumers. The Fidelity Personal Retirement Annuity charges annuity fees of 0.25% per year (0.10% for initial investments of $1 million or more) and has 57 investing options. Vanguard’s variable annuity charges 0.29% in administrative and M&E fees, and fund fees range from 0.15% to 0.44% per year.
John Ohl saved a bundle by switching annuities. About 13 years ago, he bought a MetLife variable annuity to boost his tax-deferred retirement savings after maxing out his 401(k) and IRA. He bought another MetLife annuity a few years later. But when Jefferson National introduced its low-cost variable annuity, he found he could save about 1.5% in annuity and investment fees every year, plus get better investing options.
He did a 1035 exchange from his first annuity in 2011, and he moved the second annuity as soon as the surrender period was over two years later.
Follow Ohl’s example of watching surrender charges if you consider switching. Many variable annuities assess a surrender charge of up to 7% to 10% for leaving (whether by cashing out or switching) within the first seven to 10 years after buying the annuity. Ohl’s original annuity had a surrender fee that started at 8% of the account balance and gradually decreased over eight years (the Jefferson National, Fidelity and Vanguard annuities do not have surrender charges).
But if the difference in fees is extreme, switching during the surrender period could pay off. “As you get within one to three years before the end of the surrender period, depending on how large the annuity is, it can make sense to switch and pay the penalty,” says Mike Krol, of Waldron Private Wealth, in Pittsburgh.
Jefferson National and Vanguard have calculators to help you figure out how much you can save by switching to their lower-cost versions, based on your specific annuity and when it was purchased.
When There’s an Income Guarantee
The decision to switch becomes more complicated if you’re paying for an income guarantee on the annuity, which promises that you can withdraw a certain amount of money every year for the rest of your life, even if your investments lose value or you live so long that the account runs dry. Vanguard, for example, offers the option of paying 1.2% extra to lock in the value of the investments on the policy’s anniversary each year and bumps up the benefit base if the investments’ value has increased on that date. You can take 4% of the benefit base each year for the rest of your life if you start withdrawals between ages 59 and 64, or 5% if withdrawals start between ages 65 and 79. Some annuitiesalso promise to bump up the guaranteed value by 4% or 5% per year, if more than the high-water mark.
But you can only access these guarantees as lifetime income—often at 4% per year—not as a lump sum. If you cash out or switch to another annuity, you’ll only get the actual value of your investments—not the guaranteed value. If your investments are worth $100,000 but the guaranteed value is $150,000, you’ll only get the $100,000 if you switch to another annuity.
Figure out if you’d give up any guarantees by switching to another annuity, and also decide whether you still need a guarantee at all. You may have retired since you originally bought the annuity or built up enough savings that you no longer need the guarantee. “Understandwhat the real use of the annuity is for and how it fits within your overall retirement plan,” says Krol.
If you still want the guarantee, keep in mind that the guarantees sold on annuities before 2010 tend to be more generous and less expensive than those available on new annuities, says Mark Cortazzo, a certified financial planner in Parsippany, N.J. His Annuity Review service charges $299 to analyze two annuities, such as the one you have now and the one to which you’re considering switching.
Also consider whether you still want an annuity at all. Another way to get out of the annuity without the tax bill is to make a 1035 exchange from the annuity to pay long-term-care insurance premiums. If you need care, you’ll receive benefits from the long-term-care insurance policy tax-free.
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