Americans, particularly retirees, have historically been buyers of variable annuities. But lower tax rates on profits from the sale of investments have resurrected an old debate: are taxable mutual funds a better investment for accumulated savings than variable annuities? Lower capital gains tax rates certainly make many taxable mutual funds more attractive than they were before. Yet variable annuities still may be suitable for some investors seeking retirement income.
A variable annuity is basically a mutual fund inside a tax-deferred insurance wrapper. Investments are made in mutual funds or mutual-fund-type accounts offered by the particular annuity. The investments are not tax deductible since usually variable annuities are sold outside tax-deferred accounts as they already have a tax-deferred component. Then the earnings grow tax deferred until they’re withdrawn, usually at retirement. Payouts from variable annuities can be guaranteed for life, regardless of how much the account actually earns, and there can be a death benefit guarantee. But payments may fluctuate up or down depending on investment performance of the underlying investments.
The catch is that these guarantees add to the expense of variable annuities when compared with mutual funds. This drags on the total return earned by the variable annuity investor. Many financial planners recommend that investors first take maximum advantage of other tax-deferred retirement vehicles before considering variable annuities. They argue that these vehicles generally have lower expenses, plus the added advantage of deductible contributions.
In addition, annuities have a couple of little-noticed tax drawbacks for both the annuity owner and his heirs. How can this be? After all, the enormous appeal of variable annuities is that your money grows tax-deferred until you take it out. That’s true. But when you do take it out, the money is taxed as ordinary income rather than at more favorable tax rates for capital gains and qualified dividends.
For example, if you’re in the big-ticket tax bracket, you’ll be paying 39.6% on gains when you withdraw your money, instead of the lower 15% or 20% long-term capital gains rates. And that will be true regardless of whether the withdrawn dollars are a result of income dividends or capital gains distributions.
Finally, variable annuities can hit your heirs with a big unexpected income tax bill. How so? Say you invest $25,000 that grows to $100,000 over the years, and then you die. Your heirs will owe income taxes on $75,000. If you are in a lower tax bracket than your heirs, it might make sense for retirees to take distributions before death if there are no surrender charges.
In contrast, if you owned taxable mutual funds or other securities, your heirs would not have to pay a penny of taxes on the $75,000 in gains. That’s because taxable mutual funds enjoy a “stepped-up” basis at death for tax purposes. It’s one of the few bona fide tax loopholes around.
Nonetheless, some investors may still find variable annuities attractive for other reasons:
- Unlike investments in tax-deferred accounts, there is no limit to the dollar amount that can be invested tax-deferred in a variable annuity (unless it, too, is held inside a tax-deferred account).
- Not all investors, especially older ones, invest primarily in stocks or other investments that generate capital gains. Investors preferring bonds, for example, will find their after-tax income closer to variable annuity investments because interest income is taxable at ordinary income tax rates, just as it is with variable annuity withdrawals.
- Annuity investors can switch from one investment to another within the annuity’s menu of choices without paying taxes. Investors cannot make a similar switch among taxable mutual funds. This allows annuity investors more flexibility in adjusting their portfolio.
Ultimately, the decision of whether to invest in a variable annuity or a taxable mutual fund will depend on the investor’s personal situation: age and expected lifetime, reason for the investment, liquidity needs, fees, estate plan, and their overall portfolio. The best idea is to contact the professionals at Trust Point, where we can review your individual circumstances and assist in making some sound financial decisions that will help you reach your financial goals.
The articles and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual.