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By Janet C. Arrowood
Variable annuities (VAs) can play an important role in your
client’s investment portfolio, but there are also potential pitfalls
you need to beware of. There are definite near-term tax advantages with
any annuity product but taxes are only deferred, not avoided. As a result,
the ultimate impact of future taxes must be considered. There are also
major suitability issues to be addressed, as well as many payout options
that involve annuitization or withdrawals. In addition, there are distribution
plans that need to be made.
Tax considerations
VAs have the same tax-deferral advantages as traditional annuities and
many types of retirement plans. It is important to ensure that your clients
understand that these taxes are only deferred, not avoided, and that the
taxes are due when money is withdrawn or distributed as annuity payments.
Furthermore, the taxes are due at ordinary income tax rates, not capital
gains rates, although H.R.3320 (the Lifetime Annuity Payout Act) proposes
lower tax rates for certain life-contingent annuity payments for nonqualified
annuities. Keep in mind that early withdrawal or surrender of any annuity
triggers immediate tax consequences and possible penalties. Finally, make
sure you consider your clients’ current and future tax brackets to
see if deferring taxes makes sense. The higher marginal tax rate may offset
the current costs of investing in mutual funds or other equities because
they have a more favorable current tax rate.
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| Not all clients are suitable
nonqualified VA investors. The penalties for early withdrawal are
substantial. |
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Suitability issues
Not all clients are suitable nonqualified VA investors. The penalties
for early withdrawal are substantial. VAs can, and do, lose significant
value. Because they are insurance-based products, VAs have various guarantees
not found in mutual funds or other equity-based investments, but there
are costs associated with those guarantees. Annuities generally have higher
fees and other costs than comparable mutual funds. You need to make sure
you know the Morningstar ratings for the investment options within a given
VA and ensure those ratings track with your clients’ near- and long-term
investment goals. Clients in low tax brackets may not be suitable VA investors
unless your analysis shows that they will remain in a low tax bracket
at retirement. If your clients are likely to amass significant qualified
and nonqualified assets for retirement, they may be deferring at 10, 14
or 27 percent today for the privilege of paying 30 percent or more tomorrow.
Annuity payout options
Many clients purchase a nonqualified annuity contract for its tax-deferral
features and guarantees. They have no intention of ever annuitizing the
contract; instead, they plan to take a series of withdrawals and have
the balance pass to their heirs. Their intentions have major tax and suitability
implications. Withdrawals will be taxed at ordinary (marginal) income
tax rates down to the clients’ basis in the contract; subsequent
payments (return of basis) will be tax free. If H.R.3320 does not pass
in its current form, annuitized payments will be taxed at the client’s
marginal income tax rate on the portion attributed to growth and will
be tax free for the portion attributed to basis. Under H.R.3320, the top
rate for the portion of an annuity payment attributed to growth will be
20 percent and only 10 percent for many annuitants; the tax implications
for withdrawals would not change.
Distribution planning
Technically, the money in a nonqualified VA may never have to be withdrawn,
but the provisions of the annuity contract must be examined carefully.
As with any type of investment (retirement or otherwise), there are several
factors to consider. These include current tax implications, future tax
consequences, current cash flow needs, how the funds will be distributed
and suitability.
If your client’s primary objective is current tax avoidance,
and she is “suitable” as a VA investor, the VA may pass intact
to her heirs. There are interesting tax strategies here that are beyond
the scope of this column.
If your client’s main goal is to have additional retirement
income with current tax deferral, you need to assess the current tax situation,
future tax consequences, and planned distribution of the funds—through
annuitization or planned withdrawals. The future tax consequences are
different in each case, and the differences may be substantial.
VAs and IRAs
Using a VA (or traditional annuity) as the vehicle for an IRA (particularly
a Roth IRA) is fraught with risks. Because the IRA itself is already tax
deferred (or tax free for a Roth), the use of a tax-deferred vehicle is
under constant scrutiny by the SEC and other entities. In very few cases,
the underlying guarantees of an annuity may outweigh the additional costs,
but the regulatory oversight does not go away. This is an issue between
you and your broker-dealer or general agent, but my advice is to proceed
with extreme caution.
Note that some retirement plans, primarily tax-sheltered
annuities, are based on variable annuities. In these cases (qualified
retirement plan annuities), the tax considerations are less applicable,
but the suitability considerations will apply. Most of the information
in this column applies to nonqualified variable annuities, unless otherwise
stated.
Janet Arrowood is an Evergreen, Colorado-based freelance
writer. You can reach her at jc_arrow@hotmail.com.
You can also visit her website at www.TheWriteSource.org.
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