INVESTOR INFORMATION: VARIABLE ANNUITIES
What Are Variable Annuities?
Although variable annuities offer investment features similar in many respects to mutual funds, a typical variable annuity offers three basic features not commonly found in mutual funds:
- Tax-deferred treatment of earnings;
- A death benefit; and
- Annuity payout options that can provide guaranteed income for life.
Generally, variable annuities have two phases:
- The "accumulation" phase when investor contributions - premiums - are allocated among investment portfolios - subaccounts - and earnings accumulate; and
- The "distribution" phase when you withdraw money, typically as a lump sum or through various annuity payment options.
If the payments are delayed to the future, you have a deferred annuity. If the payments start immediately, you have an immediate annuity.
As its name implies, a variable annuity's rate of return is not stable, but varies with the stock, bond, and money market subaccounts that you choose as investment options. There is no guarantee that you will earn any return on your investment and there is a risk that you will lose money. Because of this risk, variable annuities are securities registered with the Securities and Exchange Commission (SEC). The SEC and the Financial Industry Regulatory Authority, Inc (FINRA) also regulate sales of variable insurance products.
Evaluating Variable Annuities
Before you consider purchasing a variable annuity, make sure you fully understand all of its terms. Carefully read the prospectus. Here are seven factors you should bear in mind before investing:
1. Liquidity and Early Withdrawals
Deferred variable annuities are long-term investments. Getting out early can mean taking a loss. Many variable annuities assess surrender charges for withdrawals within a specified period, which can be as long as 6 to 8 years.
Also, any withdrawals before an investor reaches the age of 59 ½ are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.
2. Sales and Surrender Charges
Most variable annuities have a sales charge. Like Class B shares of mutual funds, many variable annuities shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example, a surrender charge could start at 7% in the first year and decline by 1% per year until it reaches zero.
3. Fees and Expenses
In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses when you invest in them, such as:
These annual fees on variable annuities can reach 2% or more of the annuity's value. Remember, you will pay for each variable annuity benefit. If you don't need or want these features, you should consider whether this is an appropriate investment for you.
4. Taxes
While earnings in a variable annuity accrue on a tax-deferred basis - typically a big selling point - they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains, but allow your contributions to reduce your current taxable income. That's why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans. To learn more about 401(k)s, please read Smart 401(k) Investing.
Once you start withdrawing money from your variable annuity, earnings (but not principal), will be taxed at the ordinary income rate, rather than at the lower capital gains rates applied to investments in stocks, bonds, mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year.
Furthermore, proceeds of most variable annuities do not receive a "step-up" in cost basis when the owner dies. Other types of investments, such as stocks, bonds, and mutual funds, do provide a step up in tax basis upon the owner's death.
5. Bonus Credits
In an attempt to attract investors, many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity, generally ranging from 1% to 5% for each premium payment you make. Bonus credits, however, are usually not free. In order to fund them, insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods.
6. Guarantees
Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company's financial strength. Information about these agencies can be found on the Securities and Exchange Commission’s Web site.
7. Variable Annuities within IRAs
Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.
Also, if the annuity is within a traditional (rather than a Roth) IRA, the government requires that you start withdrawing income no later than the April 1 that follows your 70½ birthday, regardless of any surrender charges the annuity might impose.