Posted: October 12, 2012
The brave new world of variable annuities
This much-maligned investment deserves another lookBy Aaron Grey and Robert Grey
3. Variable annuities place strict limits on an investor’s choice of funds.
Most “traditional broker-sold” variable annuities offer a limited selection of funds—less than 40 on average. Instead of offering a broad range of choices from independent third party managers, many traditional VAs are likely to offer their own proprietary funds. And when that traditional VA includes an income guarantee, the selection of funds ratchets down even further.
But this new type of variable annuities designed for tax-deferred investing offer a broad selection of funds—small, mid, and large-cap equities, fixed income, non-correlated assets and alternative strategies—all the way up to 380 different tax-deferred funds from one VA, at last count. The choice of fund families can include household names, such as Fidelity, T. Rowe Price, Janus and PIMCO. Access to low-cost fund managers like Vanguard and Dimensional Fund Advisors offering passively managed institutional quality funds may also be available.
4. Variable annuities are tax-inefficient because earnings are eventually distributed as ordinary income.
It’s true that when earnings from variable annuities are eventually distributed, they are taxed as ordinary income—but that doesn’t make VAs tax-inefficient. Indeed, taxable gains on the sale of a mutual fund are deferred within a VA until withdrawal. The benefit that comes from years, even decades, of tax-deferred compounding can help to mitigate the impact of paying future tax bills. And in many cases, investors are in a lower tax bracket during retirement when they begin making their withdrawals.
Also consider that many types of assets are unfriendly, even downright ugly, when it comes to paying taxes. Coupon payments to bond holders, for example, are taxed as ordinary income. Actively managed mutual funds are required to annually distribute capital gains. By locating bonds and other tax-inefficient assets within the tax-deferred wrapper of a low-cost, no-load variable annuity, investors can engage in tax-efficient “asset location” in addition to “asset allocation”:
Locate “tax-ugly” assets such as most bonds, commodities and any actively managed or alternative strategy funds in tax-deferred qualified plans or variable annuities.
Locate “tax-friendly” assets such as passively managed equity funds, which are taxed at the lower long-term capital gains rates, in taxable accounts.
5. Variable annuities lock up your assets and are costly if you need to withdraw funds early.
The fact is that most variable annuities are sold on commission—and that means they also include a steep surrender charge that can lock up your assets for 5 to 7 years, or more. The good news is once these surrender charges have expired the expensive commission-based VA contracts can be exchanged to a new, low-cost, no-load VA contract through a “tax-free 1035 exchange.” However, consumers should consult with an unbiased expert such as an independent fee-only financial advisor, CPA or tax consultant to assist in the transition and avoid an untimely taxable event.
The new type of variable annuities does not impose a surrender period or surrender charges of any kind. Now it’s possible for investors to save more tax-deferred with these variable annuities and still maintain access to their assets. As with qualified plans such as 401(k)s and IRAs, investors may face a tax penalty for distribution before age 59 ½, so be sure to work closely with your advisor to determine realistic liquidity needs before investing in a tax-deferred VA .
While there are still many reasons to exercise caution when it comes to broker-sold conventional variable annuities, it’s clear that the new breed of low-cost, no-load VAs is well worth another look for many investors—especially the 77 million baby boomers who by many measures have not saved nearly enough for retirement. By helping to maximize the power of tax-deferral with lower cost, no commissions and a broader selection of tax-deferred funds, variable annuities can help investors build a nest egg more quickly, generate more retirement income, and potentially leave a larger legacy for their heirs.
Robert Grey AIF® is the founder of Denver Money Manager. Since 1984 he has been at the forefront of the maturation of the fee-for-service financial planning and investment management industries. Rob's experience in the financial services industry spans over 30 years, and includes the areas of banking, insurance, and investments.
Since 2003, Aaron Grey has working as a fiduciary financial advisor for his clients at Denver Money Manager LLC. Aaron is a Certified Financial Planner™ and holds a BS in Chemical Engineering from the University of Colorado. The Denver Money Manager Advisory Team specializes in integrated financial planning and investment management; taking a holistic view of a client's entire financial life to develop a cohesive blueprint designed to allow them to experience “Financial Serenity.” Contact Aaron at firstname.lastname@example.org or 303-675-6771.