INVESTMENTS  -  ANNUITIES
 
 

Are Variable Annuities Still Worthwhile Under the Current Tax Rules?

Tax-deferred variable annuities have lost much of their charm with the lower capital gains tax rates enacted in 1997. Though their growth typically consists of capital gains, now taxed at a maximum rate of 20 percent if held outside a tax-deferred account, all earnings are taxed upon withdrawal at ordinary income rates of up to 39.6 percent. But variable annuities still have a place in the portfolios of many working-age investors. As is the case with many other investments, one key to making the most of a variable annuity is to buy and hold. Another key is to avoid taking a lump sum payout.

How a variable annuity works

Essentially, a variable annuity is a single- or multiple-premium life insurance annuity contract designed to provide tax-deferred earnings accumulation plus income payouts for a guaranteed period of time after some specified date, typically after retirement, when the annuity owner’s income tax bracket may be lower. While a single lump-sum payout is possible, that option rarely makes sense, and payout usually takes the form of regular withdrawals for a designated period and/or through a lifetime of fixed or variable payments through a series of systematic payments from the deferred annuity. In exchange for tax-deferred capital growth, reduced risk through the ability to invest in a range of mutual funds in the deferred annuity account, and regular income in retirement, the variable annuity investor trades liquidity and, because of additional fees assessed by the deferred annuity company, some potential return.

The annuity is “variable” because the value and earnings of the underlying investments vary with market conditions, and the amount available for eventual withdrawals or income payments varies with the investment portfolio’s market value.

When a variable annuity should be considered

Under the new tax rules, a variable annuity should still be considered when careful evaluation indicates a probable shortfall in retirement income: because of their tax-deferred compounding, annuities still allow investors to build up retirement income faster than any other way except qualified retirement plans. And variable annuities possess features in addition to tax-deferred growth that make them useful vehicles for some sophisticated strategies suitable for more affluent investors, particularly in estate planning. But investors should consider purchasing an annuity contract only when they are certain they can make the maximum annual contribution to every other available tax-advantaged retirement plan, including an IRA (whether deductible or nondeductible) as well as any company-sponsored or self-employed retirement plan.

Variable annuity advantages

Certain working-age investors are most apt to find a variable annuity attractive:

 • Investors who favor actively traded mutual funds: they will not reap full advantage from the lower capital gains rates,
    which require an 18-month holding period. If most of the fund's capital gains are taxed at 28 percent or higher,
    the deferred annuity becomes more attractive.

 • Active investors: within their annuity’s portfolio, they can allocate assets and then rebalance as often as necessary
    with no tax consequences

 • Investors who will use an annuity’s death benefit as a hedge against market fluctuations to permit aggressive investing

 • Investors who expect to be in a lower income tax bracket after retirement

Important considerations when selecting a variable annuity

There are three main factors to consider when choosing a variable annuity: the accumulation period, the payout period, and the associated expenses.

Accumulation period. This is the period between the first contribution, or premium payment, and the date payouts begin. When investments in deferred variable annuities are evaluated against comparable investments in taxable mutual funds, a key factor is the breakeven point -- the number of years it would take for the annuity’s tax-deferred compounding to offset its higher expenses and tax consequences. Breakeven calculations tend to vary widely, however, because they depend on complex assumptions about tax rates and returns. One recent study concluded, for example, that with the new capital gains rate, it would take variable annuity investors in the top income-tax bracket 23 years to break even (up from 18 years) and investors in the 28 percent bracket 17 years (up from 12 years). Another study using different assumptions found a breakeven range of only one to 11 years and concluded that the new capital gains rate increased variable annuity breakeven by no more than two years.

Payout period. Taking a lump-sum payout from a variable annuity makes no more sense than taking a lump-sum withdrawal from an IRA. But spreading payout over a number of years magnifies the annuity’s advantage over a comparable investment in a taxable mutual fund: with a long payout period, the money in the annuity account decreases slowly, leaving a substantial portion to continue its tax-deferred compounding.

Expenses. Relatively high expenses that reduce the rate of return have always been a major consideration with variable annuities. And the new tax rules have made expenses even more crucial, since they increase the time it takes the annuity to break even with a comparable taxable mutual fund investment. (One recent study concluded that an annual increase of only one-quarter of one percent in annuity expenses increased breakeven by three years for investors in the 39.6 percent tax bracket, and five years for investors in the 28 percent bracket.)  Several variable annuity issuers have responded to this issue by lowering their expenses.  If you're considering a lower-cost variable annuity, be sure to check those offered by the large mutual fund companies, including Fidelity, T. Rowe Price, Scudder, and Vanguard.

Conclusion

Investors wishing to shelter retirement income through a variable annuity should follow these strategies:

 • Don’t contribute to a variable annuity until all other available tax-advantaged retirement plans can be fully funded

 • Select the lowest cost annuity whose underlying investments meet performance requirements. Check out the following companies that offer lower-cost annuities:

      Fidelity
      TIAA/CREF
      T. Rowe Price
      Vanguard

 • Invest aggressively within the annuity, emphasizing stock funds; put less aggressive investments into taxable accounts to take advantage of the lower capital gains tax rates

 • Plan to contribute to the annuity for a period of years past the breakeven point: the longer the accumulation period, the greater the advantage of a variable annuity

 • Withdraw the money gradually after retirement: again, the longer the payout period, the greater the advantage of a variable annuity.