Look Before You Leap Into Variable Annuities
Variable annuities, already soaring in popularity thanks to the aging of the baby-boom generation, may get another shot in the arm from President Clinton’s yet-to-be-enacted economic plan.
Life insurers say the variable annuity business has “virtually exploded,” with sales jumping a whopping 56% in 1992 alone. And now that President Clinton is proposing to significantly hike tax rates, variable annuities are looking even more attractive to investors anxious to defer taxes on their investment earnings.
“Higher taxes always make a product like this more popular,” says Alice Telian, annuity consultant at New England Mutual Life Insurance Co. in Boston. “Once we know for sure what Clinton is going to do, we would expect to see more of an effect.”
However, variable annuities are not a product to jump into lightly. While they can offer the dual advantage of allowing investors to earn comparatively high returns and pay no taxes until the money is withdrawn, they also exact heavy penalties against those who opt out before their time. Additionally, by and large, the fees you pay on a variable annuities are high.
That’s because variable annuities are a hybrid retirement product that wrap an insurance policy around mutual funds. You pay fees for both the insurance and the management of the mutual funds. You must weigh the tax benefits you’re getting against the cost to determine if a variable annuity makes sense. Some people will find they’re better off just investing in mutual funds, regardless of the tax advantages.
How do you make that determination? It’s not easy. Like many insurance products, variable annuities can be complex.
Overall, many experts say you should only consider a variable annuity if you are in the highest federal tax bracket; you are capable of leaving your funds largely untouched until retirement, and you’re comfortable making investment decisions and taking some investment risks.
In some ways, variable annuities resemble the 401(k) plans that some people have at work. For example, each variable annuity company offers several investment choices--perhaps a stock fund, a bond fund, a money market fund and a guaranteed interest fund. You get to choose how much of your investment you want to put in each option. How well you choose will determine how much money you have in the end.
Also like 401(k)s, your investment earnings accrue tax-free until you pull the money out at retirement. But if you take the money out early, you may be faced with taxes and penalties that could amount to half of your investment earnings or more.
However, in other ways, variable annuities differ substantially from 401(k) plans.
First, you make contributions to an annuity with after-tax dollars. Those who contribute to 401(k) plans do so with pretax dollars, which is a significant advantage.
Secondly, you get a slight insurance component. Generally, this insurance protects your heirs from your poor investment decisions.
Specifically, the standard variable annuity promises to pay your heirs the amount you invested or the amount you have in your account, whichever is greater, if you happen to die before pulling your funds. So if you have a heart attack while worrying about a 20% drop in the value of your annuity, your heirs won’t suffer. If you live, however, you’ll suffer because you’ll have less retirement money.
And finally, where you just get hit with tax penalties when you withdraw 401(k) funds early, you usually must pay both tax and insurance company penalties when cashing out a variable annuity.
That’s because most annuity companies levy “surrender fees” against anyone who takes their money out in the first five to 10 years. Surrender fees vary, but they can start at 10% of your account value in the first year or two and ratchet down to 1% by year 10. The average surrender fee starts at 6% or 7% and phases out by year seven. But a few companies continue to charge these fees for the life of the contract.
Tax penalties kick in if you cash out of your annuity before age 59 1/2. These penalties amount to income tax--at your regular income tax rates--on your annuity earnings, plus a 10% excise tax. If, however, you don’t need the money but want to switch annuity companies, you can do that without tax penalties through a so-called 1035 exchange.
