Annuities and Minor Children: Why the Two Don’t Mix
It’s often said that annuities aren’t for everyone, and nowhere is this statement truer than in the case of minor children and dependents, a class of investors for whom annuities are uniquely ill suited.
Often parents, grandparents, guardians or executors come up with what they think is a brilliant idea: helping someone under age 18 financially by investing in an annuity on the child’s behalf. Given an annuity’s obvious benefits of low risk, guaranteed growth and stable, consistent income over time, on its surface an annuity seems like a great gift or a sound part of a long-term financial plan for a child relative or minor dependent.
While annuities do offer these benefits, it’s important to remember that annuities are designed almost exclusively for retirees.
Why are annuities such a bad idea for kids? Here are the top five reasons.
1. Ten-percent early withdrawal penalty
First and foremost, annuities have a built-in rule that, in most instances, you cannot withdraw the money without penalty until age 59 ½. If the annuitant withdraws money before this, s/he will automatically incur a 10-percent penalty – the same penalty levied against early withdrawals from retirement-saving stalwarts, the traditional IRA and 401(k). So unless your intention is to keep money sheltered in the annuity until the beneficiary reaches age 59 ½, the annuitant immediately forfeits 10-percent of the money upon withdrawal.
If that’s not enough, here are a few more reasons why annuities aren’t built for minors and young adults.
2. Last-in, first-out earnings taxation
Unlike mutual funds and ETFs, which offer an option, annuity withdrawals are taxed on a last-in, first-out basis. LIFO means that annuitants are required to withdraw their earnings first before withdrawing the principal, and these earnings are taxed as ordinary income. So the tax implication is immediate for a young adult tapping into his/her annuity for the first time.
As the U.S. budget deficit grows, economists predict that tax rates are likely to increase. While today the highest U.S. marginal income-tax rate is 35 percent, by contrast in 1944–1945, the highest rate was a whopping 94 percent! Historically speaking, current tax rates are at a low point. Consequently, by the time s/he turns age 18, a minor must consider the tax consequences if s/he plans to withdraw a large sum – say, for college, a home, a car, or another big-ticket item.
Please speak with a CPA about annuities’ tax ramifications because Court Investment Services does not provide tax advice.
3. Loss of an investing superpower: compounding
Adding insult to this injury, the beneficiary also loses out on one of the primary advantages of long-term investing, which is the power of compounding, or reinvesting earnings to generate more earnings, which are reinvested to generate even more earnings. With LIFO, the annuitant withdraws the earnings first, which neutralizes this crucial compounding benefit.
4. That ‘guarantee’ isn’t really guaranteed
Annuities are complex life-insurance products and, as such, they feature contracts rife with disclosures and legalese that’s often difficult to decipher. They have surrender penalties, sales commissions (aka loads), and hidden costs, about which the annuitant may be totally unaware until s/he actually tries to withdraw money. Consequently, the ‘guaranteed rate of return’ touted by an annuity salesperson is always accompanied by a giant asterisk. And remember: an annuity salesperson has no fiduciary obligation to put you or the minor’s financial interests first.
Further, while an annuity’s guaranteed annual rate of return of, for example, 4 to 5 percent currently, seems attractive, it’s also quite low historically. With inflation on the rise, what seems like a good investment today – locking in a 4- or 5-percent annual return for the next ~18 years – might not seem like such a great move if future rates rise to 8 or 9 percent halfway through the life of the annuity contract.
5. Exposure to legal liability
Finally, while every state and jurisdiction is different, in California, generally, the state requires us to hold guardianship accounts’ investments in exchange-traded funds or bonds with maturities of less than five years. Failure to do so violates the California probate code and exposes the investor to legal liability should the minor come of age and decide to hold the guardian accountable for sheltering the minor’s money in a retirement product.
The Court Investment Services solution
At Court Investment Services, we specialize in providing investment services on behalf of guardianship accounts. When it comes to these accounts, minimizing costs and reducing investment risk should be your top priorities. They are our priorities, too, which is why we adhere to a flat 1-percent cost structure, require no account minimum with an attorney’s introduction, and invest in inexpensive ETFs from Vanguard, Charles Schwab, BlackRock and other reputable, low-fee providers.
CIS offers four different guardianship portfolios, which differ according to investment time horizon, and all seek compliance with local probate code. Further, there are no restrictions on withdrawals. When a minor turns age 18, funds can be made liquid and 100-percent accessible with no strings attached. There are no early-withdrawal penalties prior to age 59 ½, and a beneficiary can tap the principal first, while allowing earnings to continue to compound. Earnings, however, may be taxed at the long-term capital-gains tax rate, as is standard for most investments. Again, speak with your tax advisor for more information.
At CIS, guardians can even withdraw money on behalf of beneficiaries prior to age 18 without incurring a surrender charge or early-withdrawal penalty. The process for doing so is simple and straightforward.
Finally, while signing an annuity contract permanently locks you into a long-term agreement from which you often cannot extricate yourself without incurring a substantial financial penalty, hiring CIS to manage your guardianship account offers greater severability, flexibility and convenience.
Before buying an annuity for a minor, first consult with Court Investment Services. We specialize in serving guardianship accounts, estate accounts, and helping fiduciaries fulfill their duties more responsibly. If you have additional questions about annuities, guardianships, or better fulfilling your role as an executor, administrator or fiduciary, please contact us at (800) 880-2760 or contact@courtinvestmentservices.com.
Court Investment Services, a dba of SilverOak Investments, LLC (“CIS”), is a registered investment adviser with the State of California; however, such registration does not imply a certain level of skill or training. CIS may only transact business or render personalized investment advice in those states and international jurisdictions where we are registered/filed notice or otherwise excluded or exempted from registration requirements. Any communications with prospective clients residing in states or international jurisdictions where CIS is not registered or licensed shall be limited so as not to trigger registration or licensing requirements.
The information herein has been provided for information purposes only, and is not intended to serve as investment advice or as a recommendation for the purchase or sale of any security. The information herein is not specific to any individual’s personal circumstances. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. While the information herein has been obtained from publicly available sources, which CIS believes to be reliable, CIS cannot and does not guarantee the accuracy, adequacy or completeness of any such information. The information herein may change from time to time without notice, and CIS has no obligation to update this material.
CIS does not provide tax or legal advice. To the extent that any material herein concerns tax or legal matters, such information is not intended to be solely relied upon nor used for the purpose of making tax and/or legal decisions without first seeking independent advice from a tax and/or legal professional.
All investments involve risk, including loss of principal invested. Past performance does not guarantee future performance. Individual client accounts may vary. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
For a copy of CIS’s current form ADV 2A Brochure that includes a description of our services provided, fees charged and other important information, please call us at (800) 880-2760.
© 2018, CIS. All rights reserved. No part of this publication may be reprinted without the prior permission of the author.
