Money put into these products grows on a tax-deferred basis just as it does in retirement accounts. In the case of annuities, the money is eventually taxed as ordinary income when it is taken out. With permanent life insurance, the death benefit goes to the beneficiaries free of income tax, but if it is a permanent policy, as opposed to a term policy, the owner of the policy could also borrow against its cash value and never pay income tax on it. (The insurance company charges interest on the borrowed money, though, and that loan reduces the value of the death benefit if it is not paid back.)

And while insurance companies are using the tax issue as a selling point, that is by no means the full picture. I have written recent columns on how this year’s tax increases have influenced behavior around estate planning and investments. As in those two cases, the decision to buy various life insurance policies or annuities can be unduly influenced by the tax advantages inherent in insurance. Many policies carry high upfront and management fees, have limited investment options and penalize people for withdrawing their money within a few years of buying the policy or annuity.

With these downsides, insurance companies are regularly looking for reasons to sell their products beyond the death benefits of insurance and the steady income stream of annuities.

“Oftentimes these products are sold based on the moment in time,” said Richard Coppa, managing director of Wealth Health, a financial advisory firm. “A couple of years ago, they were sold on guaranteed returns of 6 or 7 percent because people were so fearful. Today, it’s uncertainty about taxes because many of the favorable tax treatments out there are subject to negotiation.”

He said there were certainly people who were afraid of running out of money in retirement who could benefit from an annuity. He pointed to people with $250,000 to $500,000 in assets who could calculate how much money on top of Social Security they would need and buy an annuity that would cover that.

“I think you really need to run the numbers and understand the charges and compare those to an investment portfolio where you’ll get an expected rate of return,” he said.

Given the lure of tax-deferred savings, how should people weigh that against the risks and downsides of insurance and annuities?

Thomas Pauloski, national managing director at Bernstein Global Wealth Management and a former insurance company executive, said people could go wrong when they did not fully consider how long they wanted to keep their money in an insurance policy and how much the company was charging them in fees.

If they are going to pull out the money out in a few years, insurance makes little sense since fees will cancel out any gains. What’s trickier is knowing what those fees are going to be, even over the long haul.

Mr. Pauloski said among permanent insurance options — as opposed to term insurance, which has no cash value — only so-called private placement life insurance policies were clear about their fees, but that was because these policies were custom-made for someone paying a premium often in excess of $1 million. With more common forms of permanent insurance, like universal and whole life, finding the fees becomes more difficult, he said, because of how they get embedded in the policies.

More confusing still is how the returns on the cash value of the policy are presented, since they can mask the high fees. “Any insurance illustration is going to have a lot of assumptions built into it,” he said. “It assumes, for one, that today’s pretax dividend is going to continue forever. That is simply not going to happen.”

When presented with a proposal for a client, he said he often went back to the insurance company and asked it to redo the calculations with lower, more realistic assumptions. Even that, he said, is not perfect because it assumes a consistency that is unlikely.

With annuities, the fees start to pile up when people elect additional features, like a guaranteed, minimum payout. Those fees reduce the return and the value of the tax deferral.

Since the annuity company paid a commission to the broker who sold the annuity, there are also so-called surrender fees for taking your money out in the first five to 10 years of the annuity.

“My premise is annuities are second only to hedge funds in their ability to separate people from their money,” said Richard Del Monte, president of Del Monte Group, an investment adviser. “Generally speaking, they’re awful but there are specific situations.”

Article source: http://www.nytimes.com/2013/05/11/your-money/getting-the-full-picture-on-annuities-and-insurance.html?partner=rss&emc=rss