Fees Can Offset Tax Break of Variable Annuities
Like mythological sirens, life insurance companies are attracting investors to variable annuities by voicing an irresistible lure: the opportunity to save on taxes. Variable annuities offer substantial tax-deferring potential, and that helps explain why their sales shot up 51% last year to $7.45 billion, according to data compiled by the Investment Company Institute, a trade group in Washington.
Certainly, there’s nothing wrong with reducing taxes, but there’s a danger of rushing into anything blindly. Variable annuities are complex investments that don’t make sense for a lot of people. You should evaluate them with more than just tax considerations in mind.
Simply put, an annuity is a stream of payments generated by an investment. The basic idea has been around for thousands of years.
Annuity contracts offered by insurance companies and regulated by state or federal authorities work in this manner: You invest money, either in a lump sum or periodically, and that sum grows tax-deferred until you or your beneficiary withdraws the cash. You can choose when, and how often, to receive payments, but an annuity will generate more tax savings if you keep it in place for many years.
Unlike most other retirement vehicles, annuities allow you to shelter an unlimited amount of cash. However, you can’t deduct the amount you put into an annuity.
From an investment standpoint, annuities can be split into two broad camps. With fixed annuities, you receive a steady interest rate that’s guaranteed by the insurance company. However, it’s important to realize that there’s no federal insurance. “Fixed products are part of the insurer’s general account and can be attached by creditors” in the unlikely event that the company goes bankrupt, explains Douglas Fabian of Huntington Beach, editor of a booklet on variable annuities.
It’s also worth noting that these “fixed” payouts aren’t all that reliable. They are adjusted periodically at the insurer’s whim, at intervals ranging from many months to several years.
For mutual fund buyers, variable annuities are the more relevant choice. That’s because the typical variable product offers a selection of investment portfolios, including at least one stock, bond and money market fund. Many variable contracts also offer more exotic choices, such as gold, international and real estate funds. You can switch among these various portfolios, although the insurer might limit the number of your trades or charge you for the privilege.
Obviously, most types of funds offered through a variable annuity will fluctuate in price, and that means you--not the insurance company--bear the risk of loss. Notably, variable assets are placed in a custodial account, where they’re kept separate from the insurer’s assets. Consequently, your investment in a variable fund wouldn’t be jeopardized by an insurer bankruptcy, unlike with a fixed annuity.
In many cases, the same investment firms that manage regular mutual funds also call the shots on variable annuity funds. Fabian likes a variable product offered by Nationwide Life Insurance of Columbus, Ohio, because it offers a range of funds managed by top-notch outfits such as Fidelity Investments, Neuberger & Berman, Twentieth Century Investors and Capital Research & Management (adviser to the American Funds). “The investment-management selection is the most important criteria,” he says.
A variable annuity, in short, operates much like a mutual fund family, while providing an important tax-deferral benefit. With such an attractive mix, why wouldn’t everyone want to buy?
One reason concerns fees. Variable products pass operating and management expenses on to shareholders (as regular mutual funds do) and impose a couple of additional charges. The most significant of these is for “mortality and expense” risk, says Glenn S. Daily, an insurance consultant and author of “The Individual Investor’s Guide to Low-Load Insurance Products.” This ongoing levy can run as high as 1.25% a year and in large measure represents profit for the insurer, he says.
All told, expenses tend to eat up 1.5% to 3% of the money in a typical variable annuity each year, Daily says, making them generally more expensive than regular no-load mutual funds. These higher costs largely offset the tax advantages of annuities, at least in the first few years, he argues.
Daily says variable annuities offered by the life insurance affiliates of Fidelity and Scudder Stevens & Clark, two Boston-based fund groups, have some of the lowest fees around, without sales or surrender charges. He expects the same of a product due out later this year from the Vanguard Group. Daily points out that since some annuity charges--such as fees for switching among funds--are fixed, smaller investors tend to pay proportionately more.
Besides ongoing charges, variable annuities typically impose hefty back-end “surrender charges” that sometimes run as high as 8% or 9% for people who want out during the first year, phasing down thereafter. Retirees who fear that they might have to tap all available cash sources to meet living expenses should steer clear of products carrying high surrender charges, advises Gregory Todd, a partner with Shereff Friedman Hoffman & Goodman, a New York law firm specializing in financial matters.
In fact, surrender charges represent a formidable obstacle for anyone who might need to cash out within a few years. So do federal tax laws, which slap a 10% penalty on early withdrawals of earnings made from annuities and other retirement plans prior to age 59 1/2 (with certain exceptions).
Because of the hefty surrender charges and high ongoing expenses generally associated with variable annuities, you should first turn to other retirement accounts for long-term growth. That means taking full advantage of a 401k plan if your company offers one, a Keogh program if you’re self-employed or any other vehicles that let you deduct contributions.
It also means putting away the full $2,000 a year in an individual retirement account, even if you can’t write off the amount. IRAs have lost some appeal because contributions are no longer deductible for all workers. Even so, they allow investments to grow free of taxes until the money’s withdrawn. “The biggest advantage of an IRA is long-term tax deferral, not the tax deduction,” Fabian says.
If you still seek tax shelter after you’ve exhausted these other options, then a variable annuity might make sense. Just don’t become so mesmerized by the tax angle that you turn a blind eye to the various risks and restrictions.
ANNUITIES: PROS AND CONS
Variable annuities are relatively complex vehicles that let you invest in a family of funds inside a tax-deferred package. They come with various advantages and disadvantages compared to regular mutual funds. Here are some questions that can help you decide whether these products are suitable for you.
* Will you need the money invested in an annuity within a few years? Annuities typically impose surrender charges on cash withdrawn during the first several years. Also, you face a 10% federal tax on earnings withdrawn from annuities and other retirement accounts before age 59 1/2. That’s in addition to ordinary income taxes, levied on withdrawals made at any age.
* Are you looking for growth or income? A big advantage of variable annuities is the ability to defer taxes on stock funds and other growth investments. If you seek a steady return instead, opt for a fixed annuity, because the expenses probably will be lower.
* Have you taken full advantage of other retirement plans, such as an IRA, 401k or Keogh? You might be able to deduct the money you place into one of these vehicles. Even if you can’t write off your IRA contribution, you will probably do better by investing in a low-cost regular mutual fund through an IRA rather than putting the same amount of money into a variable annuity.
* Are you in a high tax bracket? The value of tax-deferred growth is diminished for people in lower marginal brackets.
* Do you plan to invest only a few thousand dollars or less? Expenses on variable annuities, critics say, take an added toll on smaller investors because of certain fixed charges that are applied in the same amount to all accounts, regardless of size.
* Do you expect future tax-law changes? There’s always a risk that Congress could reduce the tax-deferred benefits on annuities or enhance those on competing retirement vehicles. Earlier this year, for example, President Bush proposed some changes that could make IRAs more popular by allowing penalty-free withdrawals for first-time home buyers.
