What Are Variable Annuities?

Variable annuities are a new look. Insurers are cutting expenses and adding investment options to make their products more attractive. As a result, investors continue their decade-long practice of pouring billions of dollars into variable annuities. The lure of annuities is that there is no investment limit, you get to choose how your money is invested in a selection of mutual funds, and all investment profits are tax-deferred.

But, as I’ve argued for years, a Variable Annuity still is not a good investment for most investors. Is a variable annuity right for you?

Sure, you get tax deferral from a variable annuity, and unlike IRAs and other deferred accounts you can invest virtually any amount each year and are not required to begin mandatory distributions after age 70½.

But the price is high. Expenses and fees on the average variable annuity are about twice the cost of owning the average mutual fund, sometimes much higher. In addition, all distributions from a variable annuity are taxed as ordinary income at your highest tax rate. If you invested in the same mutual funds outside the annuity, you might earn tax-favored long-term capital gains instead.

Another disadvantage few people know about kicks in after your death. If you own stocks or mutual funds in a taxable account, your heirs get to increase the tax basis to their fair market value on the date of your death. That means all the appreciation that occurred during your lifetime won’t face capital gains taxes. But there is no stepped-up basis with a variable annuity. The annuity is taxed as part of your estate, then your beneficiary still must pay ordinary income tax as gains are distributed.

Recent tax laws added to the disadvantages of variable annuities. The maximum long-term capital gains tax rate was cut from 28% to 20%, and the latest tax law cut the holding period needed to qualify as a long-term capital gain to more than 12 months instead of 18 months.

It is clear that many investors aren’t examining all the facts when they buy variable annuities. As one of my readers, you are an informed investor. I want you to buy a variable annuity if it is appropriate for you. Here’s how to decide.

• First, maximize contributions to IRAs, 401(k)s, and any other qualified plans available to you before considering a variable annuity. The new Roth IRA, with tax-free distributions, also should be maximized before looking at a variable annuity.

• Second, examine how you will invest the money that might go into a variable annuity.If you are a buy-and-hold investor, there probably isn’t much reason to consider a variable annuity. You can get tax deferral without the variable annuities fees – and without turning long-term capital gains into ordinary income – by purchasing stocks or mutual funds and holding them for years. An exception might be if you invest in mutual funds that make large distributions each year. Otherwise, you can get solid, tax-deferred returns from a fund that has low turnover in its portfolio.If you are going to invest for high income (such as a junk bond fund) or will trade your portfolio frequently and generate short-term capital gains, then a variable annuity is an option to consider.If you are going to invest for average or low income, don’t consider a variable annuity. The extra expenses won’t be worth the tax deferral. The higher the return you anticipate from your investments, the more sense a variable annuity can make.
• Third, consider when you will need the money. Profits need to compound tax-deferred in a variable for many years in order to make up for the extra expenses and for converting capital gains into ordinary income. With a low-cost variable annuity, you shouldn’t consider withdrawing the money for 12 to 15 years. With a higher-cost annuity, you’ll need even longer to beat a taxable account.Keep in mind that you pay a 10% penalty, in addition to income taxes, if you take money out of a variable annuity before age 59½.The longer you can delay distributions with a variable annuity, the better. You are better off if you take distributions in a series of payments over years instead of in a lump sum.If you might want to leave some or all of the money to charity, don’t put it into a variable annuity. You won’t get the tax benefits available from giving stock or mutual fund shares to a charity.
• Fourth, consider your tax situation. If you will be in a lower tax bracket when withdrawals begin, you might be better off in a variable annuity than a taxable account. But you definitely don’t want a variable annuity if you will be in a higher tax bracket when distributions begin.

• Fifth, a variable annuity can be a good deal for someone who has a cash value life insurance policy when the cash value is less than the premiums you’ve paid. You can transfer the cash value tax free to a variable annuity, and profit distributions from the annuity will be tax free until they exceed the difference between the cash value and the premiums you paid.

After considering all these factors, if you are a candidate for a variable annuity, consider only annuities that don’t charge a load or sales commission and that have low expenses. The average expenses of a mutual fund are 1.4%, while the average expenses for a variable annuity are 2.08%.

The annuity with the lowest expenses is from Vanguard, with expenses ranging from 0.59% to 0.84%, depending on how you invest the account. Vanguard offers only nine mutual funds, while many high-cost annuities offer far more. If you want a wide range of options, consider the Best of America variable annuity from Nationwide Insurance. It offers dozens of funds and recently cut its expenses. The box lists other low-cost annuities to consider.

When evaluating an annuity, be careful about performance figures. Some insurers list performance fees before subtracting their high expenses. Others offer so many funds that they always can pull out one fund that has a high return over a recent period. But it often turns out that most of the offerings are poor or mediocre performers.

If you aren’t sure if a variable annuity is a good deal for you, order the Variable Annuity Analyzer software from Vanguard. You can order a disk through the mail or download it from Price’s web site. Recently it was available free, but at times a nominal fee of $5 to $10 is charged. The software is very flexible. You can change pre- and post-distribution tax rates, investment returns, age when distributions start, and methods of distributions. It is easy to use and well worth your time before putting money into a variable annuity.