Neither the insurance company, nor the tax laws are going to make it easy for you to get out of an existing annuity contract. But, if you already have one, you have some options that may substantially improve your position.

Surrender charges

As previously discussed, most annuities carry surrender charges. If your policy has just been delivered to you, you are entitled to return it under the “free look” provision required by the various states as part of any annuity policy. The free look period

generally does not exceed 10 days. Returning the policy will break your agent’s heart, but that’s not your problem. He will find another victim. Make sure that you get a receipt for the policy from the agent dated within the free look window.

If you are past the “free look” period you will have to check the policy to see how your surrender charges are imposed. The only rule of thumb you might rely on is that the higher the commission paid to the agent, the higher the surrender cost and longer the surrender period. As an example of how they might be structured, they might be structured to decrease each year by one percent starting at 9% and phasing down to 0% at ten years. Or, they might be level for seven years at 7% then drop to 0% at the beginning of year eight.

If you are faced with a surrender charge, you may at first consider holding the contact until the charges expire. But, you may often be better off to pay the surrender fees than to remain a captive. Let’s look at an example to see how this might work. Say you have a 7% surrender fee that will decreases each year until it gets to zero. But, you also realize that you could save 1.5% per year in expenses by bailing out of the contract. The total cost of the additional expenses over the next few years exceeds the surrender cost. It hurts, but you are better off to swallow hard and just do it.

Income tax and penalty

If you have gains in your contract after paying off any surrender fee, those gains will be subject to ordinary income tax upon withdrawal. Worse yet, if you are under age 59 ½, you may be subject to an additional 10% penalty tax on the gains.

If you have no gains, then taxes won’t be a problem. If your gains are small, you may be better off to pay them now and invest the proceeds in a more tax friendly fashion. But, if your gains are large in proportion to your contributions, you may be locked in. But, there is still some hope for you.

Section 1035 exchange

The tax codes do allow you to exchange one annuity contract for another without generating a taxable event. Why would you want to do this? Because there are a few true no-load annuities with very low expenses and no surrender fees. For instance, a Vanguard Variable Annuity has a Mortality and Expense (M&E) Charge of just 0.45% over the cost of the mutual fund. That might save 1% per year in M&E expenses alone compared to the annuity that you own. If you use their index funds inside the variable annuity, you might save an additional 1% per year in the fund’s expense ratio. Not a bad day’s work! Saving about 2% per year adds up over any reasonable period of time.

Another good use of the 1035 Exchange provision is escaping a low interest rate fixed annuity that has a low basis. You can swap it for a no load, no surrender fee, low expense variable annuity like Vanguard’s with a higher potential return.

Just open an account with Vanguard, and have them handle the transfer from your present variable annuity. Remember, it’s important that you not surrender the contract directly in order to take advantage of the Section 1035 Exchange provisions. Let Vanguard do it.

Don’t ever let a salesman suggest swapping an annuity that has run the surrender period out for a new annuity. That will just pay him another commission, and start a new surrender period for you. There is no new feature or bell and whistle that could possibly justify the exchange. Whenever you do a swap, just remember: No Load, No Surrender Fees, Low expenses.

Use in Qualified Plans and IRA’s

Simply put, there is no justification for using an annuity inside any qualified plan. The qualified plan itself provides the tax advantages and deferral. Annuities provide only additional costs and a drag on performance. Dump them! The good news is that because you can roll your contract into another qualified plan or IRA, you won’t be faced with a tax or penalty. (You may still have to deal with the surrender fee, if any.)

Section 403(b) plans

I have encountered many schoolteachers that believe that a Section 403(b) retirement plan must be funded with an annuity. This is absolutely not true! Many fund families including TIAA-CREF and Vanguard have qualifying plans. What these companies don’t have is an army of commission crazed sales people patrolling the halls of the local schools. Ask your administration for a complete list of approved providers and then go with the mutual fund family with the lowest charges.

Summary

I’ve tried to keep myself in check. But, by now, I think you know how I feel about annuities. If you don’t have one, I can’t see why you might want one.

If you do have one, you may want to think very seriously about how to escape. It may not be pretty, but you do have options that should leave you better off.

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Managed Account Services, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

Note: The featured writer is solely responsible for the content of this article. The opinions expressed herein are not necessarily those of MFI or BES, Inc.

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