Disadvantages of Non-Qualified Annuities

While most financial professionals tout the value of insurance or financial products, you should equally weigh the disadvantages of such a product, including non-qualified annuities. Yes, non-qualified annuities can be used as retirement vehicles and provide a lifetime income if you annuitize an annuity, at sometime in the future; however, there are important tax and liquidity issues that can arise from purchasing such an annuity.

Once you enter into an annuity contract, you have an opportunity called the free look period, in which you can cancel the policy and receive a full refund. Depending on the state laws of where the annuity policy is issued, you can cancel the policy, as the owner of the contract, within ten to thirty days after the issue of the policy, under its “free look provision.”

Afterwards, the majority of non-qualified annuities have surrender charges. These charges apply if a policy owner decides to cancel the policy after the free look period or withdraws an amount greater allowed than the “free withdraw provision” of the policy. In most cases, a contract owner may not withdraw funds under the “free withdraw provision,” until the policy’s second contract year (after the first anniversary of the policy’s issue date). Fortunately, most annuity policies’ surrender charges decline over time, on a sliding scale and may disappear, altogether, after a period of five to seven years.

Because of these surrender charges, it is not advantageous for individuals to request more than the free withdraw amount, which is usually equal to 10% of the policy’s value. If you need more funds, you could be paying a substantial penalty that is imposed by the issuer of the annuity contract. Additionally, it may take a week or two to receive a check that may be needed immediately to pay outstanding obligations (some issuers can speed up the process and overnight the check).

Like IRAs or 401Ks, the IRS has established certain tax penalties for withdraws made by individuals under the age of 59 ˝ (this does not apply in every case; please see your accountant for current exceptions). In general, there is a 10% early withdraw penalty imposed and you still have to pay taxes, at the ordinary income tax rate, on the amount of payment that includes interest. Therefore, the “free withdraw provision” of the annuity contract does not excuse you from IRS tax laws. It only prevents the issuer of the annuity from penalizing you for the withdraw.

You might consider withdrawing money from a checking, saving or other non-qualified investment product (stock, bond or mutual funds), in order to avoid the 10% early withdraw penalty imposed by the IRS for early withdraws from an annuity. However, keep in mind, that the sales of bonds, mutual funds or stocks can have tax consequences and or can cause you to sale at a price lower than your original investment. Also, cashing in a CD can cause you to pay a penalty for not holding it until its maturity date.

While non-qualified annuities have good advantages, such as tax deferral growth for retirement and opportunities to distribute wealth over a period of time (e.g. fixed period, 5 years or annuitization for the lifetime of the annuitant), they are not designed to satisfy short term debts if you are under the age of 59 ˝.

*Disclaimer: This article does not constitute financial advice. Always consult a tax advisor or financial advisor when making investment decisions.

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