Many people ask me, “What is a variable annuity?”
Here’s what I tell them: variable annuities are terrible investments in almost all cases. Never buy one.
What is an annuity?
This is a deposit with an insurance company. As long as you keep the money with the insurance company, it grows and you don’t have to pay tax on this growth. This is called “tax-deferred” growth. If you make any withdrawals after you’ve made gains, they are fully taxable as income. You can potentially defer the tax for many many years. This is the hook insurance companies use. When you ask “how much money do I need to retire,” they give you an answer…and then try to convince you that the only way to get that money is by purchasing an annuity.
What is a variable annuity?
Any annuity that allows you to invest in mutual funds is a variable annuity. Each company has a set menu of funds to choose from – but you can only invest in the funds the company offers. Some funds pay interest, others try to provide growth and still others own stocks that pay dividends and will hopefully grow. (If you’d like more information, read “What is a dividend?”)
Why does everyone want to sell you a variable annuity?
Sales people make huge commissions when they do. I know…I used to sell them. When I started my career selling investments in a bank, my manager told me to sell more annuities. I became a successful financial planner but selling annuities wasn’t part of my strategy. When I asked him why, he told me that it would help increase my income. It had nothing to do with taking care of the clients. Shortly after that conversation, I quit.
Commissions range from 6% to 10%. That means if you invest $100,000, the person who sold you the annuity pocketed at least $6,000. Guess who paid that $6,000? That’s right…you did. And the commission conversation leads us to…
Why variable annuities stink.
Fees and penalties. The funds inside the annuity have annual costs (usually about 1.5%) and the insurance company has annual administrative costs (usually another 1.5%). There can be a host of additional costs too, but let’s just say that variable annuities charge you at least double what an expensive mutual fund would.
Of course, if you are lucky enough to make a profit and withdraw it, make sure you do so after you reach age 59 1/2. If you withdraw profits before reaching that age, you’ll get whacked by the IRS with a 10% penalty.
On top of Uncle Sam’s penalties, you have to worry about the insurance company’s too. They usually penalize you if you don’t hold on to the investment for a fixed number of years. This varies with the contract you sign. I’ve seen some companies charge as much as a 20% penalty if you close the account within 15 years. YIKERS!!!!!
Also, you have to remember that mutual funds have capital gains. Capital gains are taxed at lower rates than earned income. But if you buy the mutual funds through a variable annuity, the gains are all taxed at the higher “earned income” rates. Whah…..
And consider your beneficiaries. If you own mutual funds and die, your beneficiaries may avoid paying any taxes on gains. Under current law, they do this through what is known as a “step-up” in basis. But if you own those same funds in variable annuities, they can’t take advantage of the “step-up” provision. Bummer. Even IRA beneficiary rules are far more flexible than annuity beneficiary provisions.
Is there anything good about a variable annuity?
Folks are sometimes attracted to these investments because of the guarantees, but they still rank high in the list of the best investments. Often, insurance companies tell investors they guarantee their investment and that the investor can never take out less than she invested. The only problem with these guarantees is that the investor usually has to die in order to get that guarantee. Oh…and by the way…if your contract offers this guarantee you usually have to pay an additional 1.35% every year on top of the fees we’ve already discussed.
There are other fancy-pants bells and whistles. The insurance industry is always coming up with new ways to sell you something. But if there was ever an example of “putting lipstick on a pig,” this is it. Don ‘t buy a variable annuity.
What you should do if you already own one of these lemons:
1. Determine costs to get out.
The best option is to get out of variable annuities completely. Call the company and ask two questions:
a. What penalty would the company impose if you closed the account?
b. How much has the account grown? Ask this question to determine if you have any tax liability. If you opened the account less than 10 years ago, chances are good that the gains are gone because of what’s happened in the market. (And you said there was nothing positive about the market meltdown!) If that is the case, you won’t have to worry about a tax burden.
2. Should you stay or should you go?
If you are over 59 1/2, the company won’t charge you anything to close the account. You don’t have any capital gains tax to worry about, so it’s a no-brainer. Take the money and invest it outside of the variable annuity.
If you are under 59 1/2 but the capital gains are gone, you can do the same thing because the 10% penalty won’t be a problem.
If you do have a big capital gains “problem” (you should be so lucky), consider rolling the money to another variable annuity. This will help you defer the tax. Not all variable annuities are alike. Some companies have very low expenses and don’t lock your money up. If you go this route, you’ll have to come up with a strategy of getting the money out of the account without paying huge taxes down the road. I’ll write another post on this issue in the future.
Finally, if you are in the unfortunate situation that the company still imposes a huge charge to close the account, you have to do some calculations.
In this case, consider the cost of staying versus the cost of going. Here’s what I mean. If you stay, you pay ongoing fees as I mentioned above. Let’s say the company charges you 3.5% each year in total fees. Assume they also have a 2% penalty if you withdraw the money now. That means (in this case) the move pays for itself inside of a year. You win!
Of course, you should always talk to your tax and financial advisor before making decisions like this, but I do want to leave you with one last tip. If your tax or financial advisor is the one who sold you this schlock…you might want to consider finding new counsel.
Do you own a variable annuity? What has been your experience? What got you roped into it in the first place? Have you purchased a variable annuity inside of a 401k?