Does a Fixed Annuity Make a Good College Savings Investment?

Drawbacks and Rules for Using a Fixed Annuity to Save for College

For many parents, a child’s college account is the last place they want to take big risks in the stock market. This aversion towards risk becomes even more pronounced when there are only a few years left until the money needs to be tapped for tuition. The last thing anyone would want to have to tell their child, is that they can’t go to the school of their dreams because mom or dad picked the wrong mutual funds!

This leaves many parents fighting for a competitive yield on fixed income investments such as CD’s, bonds, and money market accounts in the final years before college. So naturally, when someone at a cocktail party starts talking about the very attractive interest rate they’re getting on a tax-deferred fixed annuity, ears are bound to perk up.

But the reality is, a fixed annuity with all its rules just isn't right for everyone. Before you cash in your Section 529 account and buy a fixed annuity, here are some important facts to consider:

Taxes and IRS Penalties on a Fixed Annuity:

If you are under age 59 1/2 when you withdraw the funds from a fixed annuity, all gains are going to be taxed as ordinary income and be subject to an additional 10% penalty. If you’re over age 59 1/2, then there is no 10% early withdrawal penalty, but the income is still subject to ordinary income tax.

This means that, in a worst-case scenario, over 40% of your earnings will go back to Uncle Sam. That can sure make the higher interest rates on fixed annuities look a lot less attractive.

Fixed Annuity Surrender Charges:

Virtually every fixed annuity on the market has a surrender charge that is applied to any withdrawals taken before the end of the contract period. This surrender charge often starts around 5% and decreases each year as a fixed annuity ages. Again, spreading that surrender charge over just a few years’ earnings can make the overall lure of a fixed annuity much less enticing.

Fixed Annuity Safety:

While a fixed annuity used to carry a certain aura of safety, that has all but disappeared in recent times, thanks to numerous insurance companies going bankrupt or being bailed out by the government. In the end, a fixed annuity is only as good as the insurance company that issues it. If that insurance company goes under, your fixed annuity may very well go with it.

Should Any Parent Use a Fixed Annuity?

While a fixed annuity is not likely to be a solid choice for most parents, there’s a small percentage of the population that may want to give it a second look. That group would include parents or grandparents who will be over age 59 1/2 by the time their child is in college and who also expect to be in a relatively low tax bracket during the college years. In this case, the after-tax earnings on a fixed annuity may slightly beat the lower (but potentially tax-free) earnings on the fixed income options available in a Section 529 account or Coverdell ESA.