In our previous column we started our discussion of deferred variable annuities and mentioned some of the Bogleheads’ objections to these products, including high cost; long surrender periods with accompanying high surrender fees; unscrupulous sales tactics; and unsuitability for many investors.
In this column we’ll explore some additional downsides to deferred variable annuities as well as an option available for investors who already own one of these high-cost annuities. We’ll also cover some limited situations where a nonqualified low-cost variable annuity might make sense.
Additional Downsides to Nonqualified Variable Annuities
Besides the previously mentioned objections, there are a number of additional downsides to nonqualified variable annuities when compared with the alternative of investing in a low-cost, tax-efficient retail mutual fund in one’s taxable account.
–The gains in a nonqualified variable annuity are subject to ordinary income tax rates when withdrawn, whereas gains in a retail mutual fund held in a taxable account qualify for the more favorable long-term capital gains tax treatment, as long as the fund was held for more than one year.
–Variable annuities don’t qualify for the step-up in cost basis at the owner’s death, whereas the taxable retail mutual funds do.
–Except for contributions to older nonqualified policies issued prior to August 14, 1982, whenever an investor makes partial withdrawals from a nonqualified variable annuity, the IRS considers withdrawals to be from earnings first. That means the withdrawals are 100% taxable at the investor’s highest ordinary tax rate. Only after all earnings have been withdrawn are future withdrawals considered to be nontaxable return of principal. On the other hand, with a retail mutual fund held in one’s taxable account, partial withdrawals can be made using the specific identified share method to sell lots with the highest cost basis, thereby minimizing capital gains and the associated taxes.
Possible Uses for Low-Cost Variable Annuities
Despite all the negatives we’ve mentioned, it’s still possible that a low-cost, nonqualified variable annuity might be suitable for a limited number of investors who’ve already maxed out their available tax-deferred retirement plan options and find they still need additional tax-deferred space to hold investments, such as REITS. Since they don’t want to hold the tax-inefficient REITS in their taxable accounts, a low-cost variable annuity might make sense in this situation.
A low-cost, nonqualified variable annuity might also make sense for a limited number of investors who hold the majority of their assets in their taxable account as the result of selling a business or inheriting a large sum of money and thus have the need for additional tax-sheltered space.
Another area where variable annuities might make
sense is for doctors and others who face the real and constant threat of legal action. Since annuities are protected from creditors in some states, they offer a form of asset protection. Anyone considering using annuities for this purpose would definitely want to investigate and fully understand the level of protection afforded by his or her home state before investing in an annuity for asset protection.
There are other, more desirable options to consider before purchasing a nonqualified variable annuity, including maxing out all available tax-deferred accounts and holding tax-efficient equities in one’s taxable accounts. Tax-free municipal bonds or bond funds in one’s taxable account are also another good option for individuals in a high tax bracket.
Options for Current VA Owners
What’s an investor to do if he or she already owns one of the high-cost, nonqualified variable annuities? Fortunately there’s an escape clause. The IRS allows you to do a tax-free transfer to a low-cost annuity provider (such as the Vanguard Group) by doing what’s known as a 1035 Exchange. You simply fill out the paperwork provided by your new annuity provider and send the completed paperwork and your current annuity contract to your new provider. The new provider will make all the arrangements with your old annuity provider to transfer the funds to your new low-cost annuity.
Considerations When Making a 1035 Transfer
Since nearly all high-cost variable annuities have surrender periods and associated fees, you’ll want to check your current annuity policy to determine if your contract’s surrender period has expired. If so, the 1035 Exchange could be made without having to consider any surrender fees. However, even if you find that you do have to pay surrender fees, it may still make economic sense to proceed with the transfer, based on how much you’d save in lower fees and how long you plan to hold the annuity. You’d want to do a break-even analysis to determine how long it would take the lower cost annuity to pay you back in savings for any surrender fee you might have to pay.
You’d also want to consider any guaranteed benefits that you might forgo when making the 1035 Exchange decision.
In our next column, we’ll discuss the use of variable annuities in a qualified retirement plan, such as a 401(k) or 403(b).
Mel Lindauer, CFS, WMS is one of the founders of the Bogleheads community and co-author of The Bogleheads’ Guide to Investing , along with Taylor Larimore and Michael LeBoeuf. He is also co-author of The Bogleheads’ Guide to Retirement Planning with Taylor Larimore, Richard Ferri and Laura Dogu.