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Very few financial products have generated as much controversy as variable annuities. Many brokers and planners view them as indispensable retirement planning tools, while other financial experts warn consumers to avoid them at all costs.
There is no black-and-white answer to this issue. You need to understand the advantages and disadvantages of these investments before making a decision.
Key Takeaways
- Pro: They aren’t subject to contribution limits.
- Pro: The money in them grows tax-deferred.
- Pro: Many states protect them from creditors.
- Con: They usually come with high fees.
- Con: They are complex and hard to understand.
- Con: They can end up generating significant taxes.
How Variable Annuities Work
A variable annuity is a type of retirement account. The owner of the account has an investment fund that is intended, after retirement, to provide a regular monthly income in an amount that is subject to the fluctuations in the value of the investments selected for the account.
Variable annuities probably rank second only to variable life insurance in terms of complexity. They resemble their fixed annuity and indexed annuity cousins in that they are issued as contracts that grow on a tax-deferred basis regardless of whether they are placed inside an individual retirement account (IRA) or another tax-deferred retirement plan.
There is a 10% early withdrawal penalty for distributions that are taken before the contract owner is 59½, with certain exceptions for death, disability, or other factors.
However, variable contracts are unique in that they offer a preselected group of mutual fund subaccounts into which you allocate the premiums you pay. The values of the funds rise and fall with the markets, with no guarantee of principal.
Most variable products also contain living and death benefit riders that guarantee either a minimum account value or a stream of income (see below).
Nevertheless, even this information is not enough to allow you to make an educated buying decision. You also need to know the pros and cons of these unique products.
Variable annuities can provide superior returns over the long haul, but it is prudent to learn about the tax treatment of this financial product before you invest.
The Advantages of Variable Annuities
Variable annuities offer a package of benefits. Here are their main selling points.
Unlimited Contributions
As mentioned previously, there is no limit to the amount of money that can be placed inside a variable annuity. For this reason, they are popular with wealthy investors who are looking for tax shelters. (Most carriers impose a limit for initial purchases.)
Tax Deferral
Like all other forms of annuities, variable annuities grow from year to year on a tax-deferred basis. The distributions are taxable in the year that they are made.
Insurance Protection
Most variable contracts today offer an array of living and death benefit riders that promise a guaranteed stream of income or a minimum account value.
The living benefit riders pay out a guaranteed stream of income that is based upon a hypothetical guaranteed rate of growth from the subaccounts. You will still get this payout even if the subaccounts fall short of this rate of growth.
The typical death benefit rider promises the beneficiary the largest of three factors: the current contract value, its highest value on the date of the contract anniversary, or a value based on a guaranteed hypothetical rate of growth.
Potential for Superior Returns
People who put their money in stock subaccounts and leave it there for 20 years or more will probably see a higher return on their investment than can be had from any other type of annuity.
Most variable contracts also offer basic money management services, such as periodic rebalancing.
The fixed accounts that are available in many variable contracts are often higher than the rates offered by comparable fixed products.
Avoidance of Probate
As with fixed and indexed annuities, variable annuity contracts are unconditionally exempt from probate. That allows the beneficiaries to get their money quickly.
Protection from Creditors
Although this benefit varies somewhat by state, many states mandate that money placed inside variable or other types of annuity contracts cannot be attached by creditors. Florida, for example, offers such protection.
Initial Bonuses and High Guaranteed Rates
Many variable annuity contracts will pay an instant bonus on money that is paid into the contract, or they may offer a dollar-cost averaging program that pays a high fixed rate on the initial balance and then moves the money into the subaccounts of your choice over a set period of time, such as six or 12 months.
The Disadvantages of Variable Annuities
Despite their versatility, variable annuities are not all things to all people and do have some real limitations.
Poor Cost Basis
Unlike stocks and other securities, the cost basis of variable annuities does not step up when they are inherited. Beneficiaries will pay tax on the entire contract value that has grown from the date of the initial purchase.
Poor Tax Treatment
Although variable contracts grow tax-deferred until retirement, they impose the same 10% early withdrawal penalty as traditional IRAs and qualified plans.
All distributions from these contracts are taxed as ordinary income unless the contract was placed inside a Roth IRA.
A similar long-term investment in index funds that do not pay dividends could yield similar growth, but with total liquidity and lower taxes on long-term gains.
High Fees
Variable annuities, like L share annuities for example, are one of the most expensive financial products in the marketplace. They come with myriad fees and charges, including mortality and expense fees, mutual fund subaccount management fees, contract maintenance fees, and other miscellaneous costs. Some contracts will charge transaction fees after a certain number of transactions have been made within the contract.
Living and death benefit riders also subtract periodic fees from the contract balance.
Most contracts also come with a substantial back-end surrender charge schedule that may not expire for 10 years or longer.
Complexity
As mentioned previously, variable annuities are one of the most complicated financial instruments available today, and they are often poorly marketed and understood by both salespersons and consumers.
What Is an Annuity?
An annuity is a contract between an annuity owner and an insurance company. It offers a steady stream of income, typically for retirement.
What Is an Annuitant?
An annuitant is the individual that the annuity’s life expectancy calculations are based on. They are not necessarily the same person as the annuity owner.
What Is a Variable Annuity?
A variable annuity is an annuity with a payout that is ultimately based on the performance of the market, via mutual fund subaccounts.
The Bottom Line
Variable annuities can offer you benefits that would require a combination of several other types of investments and accounts to duplicate. However, you need to be thoroughly educated on their drawbacks.
The value of these products can only be evaluated in the context of your tax situation, investment and retirement objectives, and time horizon.
