Annuities are primarily effective for people who will be over age 59½ when education costs are incurred.
Although annuities can be successfully used as an exempt asset for financial aid purposes, shortfalls associated with investments for college include:
- Taxed as ordinary income – The 1997 tax law cut capital gains tax and left ordinary income tax high. Therefore, annuities do not have the same tax benefit at distribution as mutual funds and stocks.
- No tax deduction when purchased – Annuities are only tax-deferred, they are not tax-exempt. 401(k)s and 403(b)s are pre-tax dollars and IRAs are tax deductible. Plus, the 1997 tax law allows IRAs to be exempt from penalties when used for education. Annuities have neither benefit.
- Transfers or gifts (other than spouse) trigger a taxable event – Gifts or transfers of highly appreciated stock or mutual funds are assessed at the lower capital gains’ rate.
- Withdrawal or surrender penalties – Most annuities have considerable withdrawal or surrender penalties for the first 5-10 years or more. This penalty is on the entire amount of the annuity, not just the appreciation, and is usually associated with sales commissions.
- Additional fees for mortality and risk expense – In addition to the normal investment fees, annuities contain a “mortality and risk” expense to cover the insurance obtained. However, this insurance covers only the original investment. If the annuity account is less than the original investment and the account holder dies, the insurance covers only the difference. If the annuity account has grown and the account holder dies, the insurance pays nothing.
- 10% penalty if withdrawn before age 59 ½ – Unless an exception applies, the earnings portion of a withdrawal from an annuity will be subject to a 10% tax penalty if withdrawn by the annuitant before age 59 ½.
Caution: Variable annuities, a mutual fund-type annuity, are attractive to some families as a way to save for college. The advantages of this type of investment are their tax-deferral of earnings and ability to keep up with the high inflation rates of college. However, there are some disadvantages to these types of investments.
The possible disadvantages are:
- high selling and administration charges,
- lack of liquidity,
- lack of loan features,
- the conversion of low-taxed capital gains into high-taxed ordinary income,
- surrender charges for early withdrawal,
- a 10% penalty (except in very limited situations) for withdrawal before the age of 59½, and
- lack of ability of non-taxable transfer to charities, or transfers or bequests to anyone but a spouse (as in an estate) because of the IRD nature of the asset.
To negate some of these disadvantages, some investment firms are selling annuities with no surrender charges and low selling and administration charges.
Note: Under IRC Sec. 72(u), the income from annuity contracts not held by natural persons is considered taxable ordinary income of the beneficiary. However, the holding of an annuity by a trust or other entity, as an agent for a natural person, is exempt from this provision.