Retirement Investing Basics: Variable Annuities and Retirement Planning

If you’ve been talking to a commission-based financial planner about your retirement, then it’s quite likely you’ve been encouraged to purchase a variable annuity. Why? Because these contracts typically generate generous commissions for those who sell them. They are, however, a far-less-than-ideal investment for most future retirees. This article explains what variable annuities are, their advantages and disadvantages, and how to use them, if at all, in your retirement planning.

What is a variable annuity?

Essentially, a variable annuity is a tax-deferred investment like an IRA or a 401(k). In contrast to an IRA or 401(k), however, you cannot deduct your investment in a variable annuity from your current income, so there’s no immediate tax advantage. However, the gains generated by your investment (interest, dividends, capital gains) are tax-deferred, meaning that you do not pay income tax on them at the time they occur. When you start withdrawing money from a variable annuity, the portion of the withdrawal attributable to gains (but not to your original investment) is taxable as ordinary income.

Variable annuities also include an insurance element. If you die before using up the money contained in a variable annuity, your heirs will receive the greater of either the annuity’s current value, or the amount you originally invested. In other words, your heirs are protected against any capital losses in the annuity’s value. The cost of this insurance is deducted from the value of the annuity on a periodic basis.

Advantages of variable annuities

• Variable annuities allow money to grow tax-deferred. Gains are reinvested and create more gains, unburdened by income taxes, which are due only when you withdraw the money. This can create a substantial compounding effect over time.
• Unlike IRAs, 401(k)s and similar vehicles, there is neither an income nor a contribution limit to variable annuities. Those who are either ineligible for these investment vehicles, or who have already maxed out their contributions and want to invest additional money tax-deferred, can still take advantage of variable annuities.
• The insurance component of variable annuities protects your heirs against sudden drops in the value of money you have invested for them.

Disadvantages of variable annuities

• Charges, charges, and more charges! The fat commissions that salesmen receive when they sell you a variable annuity have to come from somewhere, namely you. You may be charged an up-front fee when you buy a variable annuity, all kinds of visible and invisible charges against your investment income while the annuity is in force, and/or a surrender fee when you go to cash it in.
• Early withdrawal penalty. If you need the money in a variable annuity before you’re 59 1/2 years old, you’ll be socked with a 10% tax penalty just as you would if you raid your IRA or 401(k) plan.
• Tax disadvantages. It’s true that the tax-deferral feature, as described above, works in your favor. But there are tax disadvantages. When you withdraw from a variable annuity (as with other tax-deferred accounts), all gains are treated as ordinary income. In other words, you lose the tax advantages of dividends and capital gains which you would enjoy if you had simply invested in stocks or mutual funds. Also, if you die before using up the money in a variable annuity, your heirs will inherit the tax liability on the deferred gains. Here, too, you’re losing a tax advantage enjoyed by ordinary investments, whose tax basis is automatically stepped-up when you die.
• The insurance cost. The cost for the insurance described above eats into your investment returns. The value of this insurance, however, is highly questionable. It only kicks in if you both die before using up the money in the annuity and the investments contained within it have declined in value. For the vast majority of investors, this insurance is simply a waste.

The bottom line

For most people, the disadvantages of variable annuities outweigh the advantages. They’d do better to invest in mutual funds in the normal way. This saves a lot of money in fees. It allows you to invest, or to cash in your investment, whenever you wish without worrying about charges and penalties. Especially if you invest primarily in stock mutual funds, much of the return on your investment will be in capital gains and dividends, which are only taxed lightly anyway.

If, however, you feel you must have the advantage of tax deferral and have no other vehicle available to you than variable annuities, you may decide to buy one. If you do, you’ll do best to avoid the variable annuities sold by salespeople and advisors, which carry a large load of fees and charges, and go with a no-load fund family like Vanguard. This will keep the burden of fees to a minimum. But don’t expect your investment advisor or insurance agent to like this idea, or even to tell you about it. If you already own a variable annuity that you bought from a salesperson that’s loaded with fees, you may be able to transfer it tax-free into a low-load annuity using what’s called a “1035 exchange.” But before you do this, find out about the surrender fees associated with the annuity you own. If they are high, you may wish to wait, since surrender fees generally decrease with time.

In any event, be sure you read the fine print. A variable annuity is a much more complicated investment than a mutual fund—which is yet another reason you should think twice before putting your money into one.