What is a Variable Annuity?

by Neal Frankle, CFP ®

what is a variable annuityA variable annuity is a deposit with an insurance company like a regular annuity.  The big difference is that you decide how to invest the money and you have many choices (including growth mutual funds).

As long as you keep your money with the insurance company, you don’t have to pay tax on any growth. This is why it’s called “tax-deferred” growth. But if you make any withdrawals they are fully taxable as income to the extent you’ve had any gains. So if you don’t take withdrawals you can defer the tax for many many years. This is the hook insurance companies use.  Let’s see if variable annuities are all the insurance companies say they are.

How can you invest a variable annuity?

As I said above, a variable annuity allows you to  invest in mutual funds. Each company has a set menu of funds to choose from – and 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.

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 didn’t like selling these contraptions so I asked him why he wanted me to do so. 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 pockets at least $6,000. Guess who pays that $6,000? That’s right…you do. 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.  Keep in mind that you pay those charges every year.

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, keep in mind that mutual fund growth outside of an annuity can be taxed at the lower capital gains rates.   Within the variable annuity those same gains are taxed at higher rates because they considered income when you withdraw the money.  WHAHHHHH…..

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.

Is there anything good about a variable annuity?

Folks are sometimes attracted to these investments because of the guarantees that are offered.  Often, insurance companies tell investors they guarantee their investment and that the investor can never take out less than they 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. That’s why I can’t see many reasons for anyone to ever 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 might be 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.

2. Should you stay or should you go?

This depends on your age, the gains, your tax liability and other aspects of your particular situation.  But if you do decide it’s best to stay under the umbrella of a variable annuity, you may have the option of rolling it to a different company if your particular provider is too expensive.

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?

 

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