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How do variable annuities work?

Last Updated:  May 4, 2016

How do variable annuities work?

Let’s start with “what is a variable annuity?” before we tackle “how do variable annuities work?”. A variable annuity is a tax deferred investment product that allows you to invest in a multitude of different types of investments. Those investments have differing rates of investment return and can be stock mutual funds, bond mutual funds, or any combination of those plus others like commodities!

Many people confuse variable annuities with fixed annuities. A fixed annuity is a tax deferred investment also, but instead of having access to a host of underlying investments a fixed annuity only pays a fixed rate of return. Both a variable annuity and a fixed annuity is generally for retirement savings.


How do variable annuities work?

Because we’re a fee only financial advisor and variable annuities are predominantly commission products, we don’t have many of them in our client base. In fact the only variable annuities we do have are those which clients had been sold prior to working with us and we’ve done a 1035 exchange into a no-commission variable annuity with. That being said, the reason we don’t sell them or use them is we actually understand how they work, and it’s not pretty for most investors.

With variable annuities, you invest a chunk of money into an insurance contract. That insurance contract allows you to pick mutual funds for the underlying investments. Those mutual funds will go up and down with whatever they’re invested in just like you owned the mutual funds outside of the variable annuity.

The benefit to variable annuities is they provide tax-deferred growth. While you don’t get a tax break for the investment, you also don’t pay the taxes on dividend distributions every year as you would in a taxable investment account. Your money grows for you in mutual funds and you can allocate it the same as you normally would according to the financial planning you’ve done. On top of that you don’t pay taxes along the way.


Why are variable annuities bad then?

Well let’s clarify that. Not ALL variable annuities are bad. We tend not to like them much for a few reasons.


The problem with variable annuities #1

Variable annuities are EXPENSIVE! Variable annuities have expense ratios from 2% to 4% per year because they have mortality expense ratios built in PLUS usually pretty expensive underlying funds. If you get any of the bells and whistles like guaranteed death benefits they’re on the high end of that range! Oftentimes the surrender charges to get OUT of them is 10% or more in the first few years (which will decline each year after). They’re pretty nice for the broker though! Many of them pay 7% + commissions!

Some are very very low cost and highly efficient. Some have amazing underlying mutual funds like those from Dimensional Fund Advisors and Vanguard. Many do not and have very limited investment options.


 The problem with variable annuities #2

They cost a lot in taxes! That’s right, I said they’re tax-deferred but I didn’t say tax-free! When you withdraw money from a variable annuity it’s taxed at ordinary income tax rates! And that’s if you wait at least until you’re 59 and 1/2. If you pull money out PRIOR to then you’ll pay a 10% penalty on the growth.

Assuming your gains in a taxable account are long term gains you’ll pay 15% typically (possibly 20% if you’re in the top income tax brackets). If you withdraw money during retirement from your variable annuity you’ll pay ordinary income taxes on a pro-rata basis. This means if you invest $100,000 in a variable annuity and it grows over the years to $200,000, you have $100,000 of cost basis and $100,000 of gains which would be taxed at ordinary income rates.

Th tax rate would likely be at 15% if the money was in a taxable account. From the annuity however the portion of gains distributed is fully taxable as ordinary income. If you’re in the 25% income tax bracket you’ll pay 25% on the earnings portion of your distribution. Granted if you had invested in interest paying bond mutual funds OUTSIDE of the variable annuity you’d pay ordinary income taxes as well – but the whole purpose of a variable annuity would be defeated in that case. The point is to GROW your money with stock mutual funds (for the most part).


The problem with variable annuities #3

There’s no tax-loss harvesting with variable annuities! If your stock mutual funds or ETF’s or shares in individual stocks (which we’d never recommend) drop below their original cost basis they can be sold for a tax loss if they’re owned in a taxable account. That tax loss can offset up to $3,000 in ordinary income each year as long as it lasts. It can also offset capital gains over time.

With a variable annuity there is no tax loss harvesting. Since the account is tax sheltered anyway you can’t write off any losses similar to your IRA or 401k etc.


The problem with variable annuities #4

Variable annuities are often one of the last assets used for retirement income due to the tax implications. For this reason they’re often left to heirs.

With a regular mutual fund or ETF your heirs would get a step up in cost basis. With the variable annuity this isn’t possible. Variable annuity beneficiaries will still pay ordinary income tax on the amount of gains left in the policy.


How do variable annuities work? The lowdown…

Part of the reason we’re so negative on variable annuities is we don’t sell them. We don’t sell variable annuities because we don’t take commissions like brokers do. That’s just the candid truth – we don’t take any commissions to sell investment or insurance products.

There’s more to it however: they’re not tax efficient, they’re generally super expensive, and variable annuities are really poor assets to leave to your heirs.

Are they all bad? NO! They’re not all bad. We have some clients with no-load super low cost variable annuities. We use them for a retirement income purpose, and generally they serve that purpose OK. The thing is UNLESS you max out your Health Savings Account (if possible) AND your retirement plan at work (think 401k), your IRA’s, your Roth’s, any backdoor Roth IRA opportunities, you shouldn’t even consider variable annuities! If you’ve maxed out all other real tax preferenced accounts then it may be worth looking into.

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