Jane M. Young CFP, EA
Due to the high costs, lack of flexibility, complexity and unfavorable tax treatment variable annuities are not beneficial for most investors. Traditional retirement accounts and Roth IRAs meet the tax deferral needs for most investors. In some instances a variable annuity may be attractive to a high income investor who has maximized all of his traditional retirement options and needs additional opportunities for tax deferral of investment gains. This is especially true for an investor who is currently in a very high tax bracket and expects to be in a lower tax bracket in retirement.
Generally, money in retirement accounts should not be invested in variable annuities. The investor is already receiving the benefits of tax deferral.
A variable annuity may also be an option for someone who is willing to buy an insurance policy to buffer the risk of losing money in the stock market. For most investors, due to the long term growth in the stock market, this guarantee comes at too high a price. However, some investors are willing to pay additional fees in exchange for the peace of mind that a guaranteed withdrawal benefit can provide. A word of warning, guaranteed minimum withdrawal benefits (GMWB) can be very complex and have some significant restrictions. Do your homework, make sure you understand the product you are buying and read the contract carefully.
According to a study conducted by David M. Blanchett – the probability of a retiree actually needing income from a GMWB annuity vs. the income that could be generated from a taxable portfolio with the same value is about 3.4% for males, 5.4% for females and 7.1% for couples. The net cost is about 6.5% for males, 6.1% for females and 7.4% for couples.
Jane M. Young, CFP, EA
What is a Variable Annuity?
A variable annuity is a contract with an insurance company where you invest money into your choice of a variety of sub-accounts, similar to mutual funds. Non-qualified, variable annuities provide tax deferral on gains until the funds are withdrawn. Upon distribution your gains are taxed at regular income tax rates as opposed to capital gains rates. Variable annuities generally charge fees twice those charged by mutual funds. Additionally, you will be to subject to substantial early withdrawal charges if you purchase an annuity from an advisor who is compensated through commissions. Most variable annuities provide the option to buy a guaranteed death benefit option and/or a Guaranteed Minimum Withdrawal Benefit. These do not come without a cost and can be very complex. Below are some advantages and disadvantages of Variable Annuities.
Advantages and Disadvantages of Variable Annuities:
- Tax Deferral of gains, beneficial if you have maximized limits on other retirement vehicles such as 401ks and IRAs.
- No Required Minimum Distribution at 70 and ½ as with traditional retirement accounts. There is no Required Minimum Distribution on Roth IRAs.
- Death benefit and Guaranteed Lifetime Withdrawal Benefits (GLWB) riders can be purchased for additional fees. However, the death benefit is rarely instituted due to long term growth in the stock market. GLWBs can be very complex and not without risk.
- Trades can be made within annuity without tax consequences – this is also true within all retirement accounts.
- Non-taxable transfers can be made between companies using a 1035 exchange.
- No annual contribution limit. Traditional retirement plans have annual contribution limits.
- Gains taxed at regular income tax rates as opposed to capital gains rates on taxable mutual funds.
- Higher expense structure –Mortality and Expense fees substantially higher than mutual funds.
- Substantial surrender charges for up to 10 years on commission products
- 10% penalty on withdrawals prior to 59 ½, this is also true with most traditional retirement accounts.
- Complex insurance product
- Lack of liquidity due to surrender charges and tax on gains
- No step-up in basis, taxable mutual funds and stocks have a step-up in basis upon death
- Loss of tax harvesting opportunities
Please join us for lunch and an interactive discussion on annuities vs. mutual funds at Pinnacle Financial Concepts, Inc. on May 16th. Our Fireside Chat will run from 11:30 to 1:00. Please call 260-9800 to RSVP. There is no charge and our Fireside chats are always purely educational!!!