MY FRIEND JIT learned the hard way that you can never be too careful when dealing with a financial advisor. Despite being a cautious and responsible investor, he made one small oversight—and ended up with his money trapped in an unsuitable product.
I’ve known Jit for more than 15 years. He’s smart and financially savvy. He saves diligently and manages his own investments. He funds his son’s 529 plan, maxes out his 401(k), uses the backdoor Roth and so on. He does pretty much everything that a rational, informed investor should do.
A few years ago, he consolidated his investments at a single online brokerage firm. He qualified for the firm’s complimentary advisory service, so he decided to get feedback on his existing investments from his designated “account consultant.”
Jit’s consultant made a few sensible suggestions and quickly earned Jit’s trust. Jit had a large amount of cash from some recently matured CDs. He debated whether to pay down his mortgage or put the money in the stock market. Tax was a consideration, too. He checked with his consultant.
The consultant suggested putting the money in the market. Given Jit’s risk tolerance and overall situation, this was good advice. The advisor, however, directed Jit’s attention to a retirement product with unlimited after-tax contributions and tax-deferred growth—in other words, a variable annuity. Jit had no interest in the lifetime income option, but the advisor argued that the product itself had no surrender charge and that the balance could be withdrawn in part or whole without annuitizing. The goodwill the consultant had already earned, coupled with convincing charts about the value of tax-deferred growth, swayed Jit. He moved a good chunk of his cash into the annuity and invested it in one of the annuity’s investment options, a total stock market index fund.
To be fair, this particular annuity is one of the better ones available. It has tons of flexibility, many fund choices and few restrictions. The cost is relatively low compared to most other variable annuities. Still, it was an inappropriate product for Jit.
Why? He was looking to make a long-term investment in a total stock market index fund. The annual dividend is a small component of the fund’s likely total return, plus it’s taxed at the favorable qualified dividend rate. There isn’t much value in deferring that tax. Indeed, the annual tax on a low-cost total U.S. stock market index fund in a taxable account would be less than the annuity’s fee.
On top of that, the total market fund in a taxable account would receive the favorable long-term capital gains rate when it’s sold, whereas the annuity will be dunned at the higher ordinary income tax rate. This was Jit’s oversight: He should’ve realized the tax treatment was different.
Even though the product itself has no back-end sales commission, Jit is many years from age 59½, when he can withdraw from the annuity without paying the IRS’s 10% early withdrawal penalty. He’s basically stuck with the annuity—and his money is going to be trapped for a very long time.
What can we learn from Jit’s momentary lapse?
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles were A Rich Life and Cost of Living. Self-taught in investment and financial planning, Sanjib is passionate about raising financial literacy and enjoys helping others with their finances. Earlier this year, he passed the Series 65 licensing exam as a non-industry candidate.