Annuity Myths: Things Everybody Knows About Annuities
Deferred Annuities:
Myths and Misunderstandings in Popular Wisdom
By John L. Olsen, CLU, ChFC, AEP
Deferred annuities are hot stuff. They’re being sold in great numbers and are the subject of continuing, and often very heated, debate as to whether they’re “worth it” (sometimes, in comparison to certain investment alternatives and sometimes, considered all on their own). In this article, we’ll consider some of the myths and misunderstandings that have crept into the discussion in an attempt to differentiate the facts from the just plain false popular wisdom.
Tax Deferral
One of the advantages enjoyed by a deferred annuity[i] is that income tax on the earnings, or “gain,” in the contract is deferred until those earnings are distributed, rather than being taxed as earned. Tax deferral is, thus, a benefit to the annuity purchaser. But that benefit comes at a cost. Many annuity critics believe that this cost is a contractual one, that it is imposed by the insurance company that issued the annuity. This is simply untrue. No deferred annuity contract (variable or fixed[ii]) contains a charge for tax deferral. Some critics assert that this is simply because the charge for tax deferral is hidden. That, too, is false. The proof of this lies in the fact that in a typical fixed annuity, there are no annually recurring charges of any kind, yet a fixed deferred annuity receives precisely the same tax treatment as a variable one, which does impose annual charges. One financial analyst I spoke with, insisted that, while this is true, it is also true an investor must purchase an annuity (an insurance product) in order to receive tax deferral, and that, therefore, the insurance costs of an annuity amount to a “cost for tax deferral.” That’s not so. U.S. government EE bonds offer purchasers the opportunity to elect tax-deferred treatment, and they are not insurance products. Finally, it should be noted that tax deferral is not granted by any investment. It is granted by Congress, which can, and does, determine which investment vehicles get it and which do not.
The cost of tax-deferral of gain in a deferred annuity lies, not in charges or expenses contained or “hidden” in the annuity contract, but, rather, in the other tax consequences— apart from tax deferral of gain—that always apply to it – namely, (1) the “all Ordinary Income treatment” of all taxable distributions from any annuity and (2) the “early distribution” penalty prescribed by IRC § 72(q). And the first of these can be said to be a “cost” only of variable annuities.
Why is that? It’s because the “all Ordinary Income” treatment of all taxable distributions from a variable deferred annuity is a “cost” only in the sense that a more favorable tax treatment (Long Term Capital Gains taxation) often applies to the gain in many investments the investor might choose as alternatives (e.g.: common stocks or funds investing in common stocks). Thus, the higher tax rate is a “cost” of investing in the instrument that imposes that higher tax rate. But the investment alternatives reasonably comparable to a fixed deferred annuity are such things as bonds, passbook savings accounts, and certificates of deposit, the gain from which is taxed, largely or entirely, as Ordinary Income. Of course, the early distribution penalty (10 percent of gain) imposed by §72(q) applies to both fixed and variable annuities and may properly be viewed as a “cost” of investing in either type.
Tax Deferred Annuities in IRAs or Qualified Plans
Another common misconception regarding the tax consequences of investing in a deferred annuity is that the benefit of tax-deferral enjoyed by these contracts is somehow “wasted” when they are used to fund an IRA or qualified plan. One often hears that funding such a plan with an annuity amounts to, “putting a tax shelter inside a tax shelter.” This notion betrays a fundamental misunderstanding, both of how tax law works and of how to incorporate tax implications in assessing the suitability of an investment as a funding instrument for a tax-deferred program.
The tax-deferral enjoyed by non-qualified deferred annuities is a creature of Internal Revenue Code Section 72. That section provides that all distributions from such contracts are either (1) “amounts received as an annuity” or (2) “amounts not received as an annuity.” The first sort are taxed under the regular annuity rules of IRC §72(b) and the second are taxed in accordance with the rules of §72(e). Neither set of rules applies to annuities that are held in an IRA or qualified plan. Thus, the tax-deferral enjoyed by a non-qualified annuity is not wasted when that annuity is used to fund such a plan because it does not apply to such plans.
Another way to look at this issue is to consider the following example. If A owns a small-cap, non-dividend paying stock or a mutual fund invested in such stocks and holds that position for more than one year, any profit will (under current law) be taxed entirely at preferential Long Term Capital Gains rates. Yet if A holds the very same stock (or fund account) inside a traditional IRA or qualified plan, all profit will, whenever distributed, be taxed at higher (Ordinary Income) rates. Employing the same reasoning that holds that an annuity is unsuitable for funding an IRA or qualified plan because it “wastes” the tax treatment that would apply if that annuity were held in “regular” (non-tax deferred) account, one would have to conclude that a small-cap, non-dividend paying, stock—or fund investing in such stock—is never suitable for funding an IRA or qualified plan, because it “wastes” the tax treatment that would apply if it were held outside that plan. Very few investment professionals or savvy investors would come to that conclusion. It’s absurd, because it seeks to apply tax considerations that are, by definition, inapplicable to what is essentially a judgment of suitability.
An annuity may or may not be suitable for inclusion in a particular client’s IRA or qualified plan. Does that client want and need the insurance features that the annuity provides? Does that client intend to take the proceeds as a lump sum or as an income (and, if the latter, over what period)? If a guarantee of principal and an assured guarantee of a minimum income for life are both important, a fixed annuity might be appropriate. What are the client’s risk tolerance (how much risk can he stand, emotionally) and risk capacity (how much risk can he afford to take, financially)? Would a variable annuity with a guaranteed living benefit rider allow that client to invest more aggressively than he would be willing to do without the guarantees of that rider, if a more aggressive allocation appears to be needed? If so, is the current and future cost of that rider worth the benefit? Is a guaranteed minimum death benefit desired? Many fixed and variable deferred annuities offer this benefit. But would a life insurance policy, if available, provide more benefit per dollar of cost? These are the sort of questions one must consider in reckoning the suitability of an annuity for a client’s IRA or qualified plan. The tax treatment that the annuity, or any other investment being considered, would get if it were not held in the plan is not among these questions, because it’s completely irrelevant.
Is The Tax Deferral Of A Deferred Annuity “Worth The Cost”?
We’ve seen that the benefit of tax deferral in a non-tax deferred account comes at a cost (All Ordinary Income treatment and the “early distribution” penalty) and that that cost applies fully to a variable contracts (but that only the §72(q) penalty “cost” applies to a fixed annuity). How can one assess whether, in a particular facts situation, the benefit of tax deferral in a variable annuity is worth that tax cost? It can be done, but it’s not easy. It requires both a willingness to consider multiple variables and an analysis tool capable of accounting for all those variables and modeling the complex ways in which changes in one or more variables impact the result.
Variable Annuity versus Mutual Fund Portfolio
A tool that I have used to compare a variable annuity with a mutual fund portfolio (both held in a non-qualified account) is the VA Investment Planner, a tool within the WealthTec® Suite software program (). That tool does an admirable job of taking into account the many variables that, in interaction, affect the “which is better?” result. After making literally hundreds of such comparisons, I have concluded that the only answer to the question, “Is a variable annuity a better instrument to produce retirement income than a mutual fund?” is “It depends.” It depends on many factors, and – most especially – on the assumptions made. That said, I am willing (albeit timidly) to offer a few general conclusions with regard to the question of “variable annuity versus mutual fund” as planning tools.
1. If the planning goal is to produce the highest after-tax lump sum future value during lifetime, the variable annuity is likely to underperform the mutual fund portfolio (assuming typical expenses and a gross return in the range of 7 to10 percent annually) unless the accumulation period is quite lengthy (greater than25 years). If the goal is to produce the highest after-tax net wealth to heirs, the annuity performs even worse by comparison (because of the lack of “step up in basis,” combined with the “all Ordinary Income” treatment of annuity distributions).
2. If the planning goal is to produce the highest income for life, the variable annuity may well outperform the fund portfolio, even in the absence of a guaranteed living benefit and even when income is taken via partial withdrawals, provided that the combined accumulation and income periods are greater than about 40 years. The longer the accumulation period and/or the income period, the better the annuity performs (in comparison to the mutual fund portfolio).
3. The often-stated “excessive” fees of the variable annuity (vis-a-vis the mutual fund portfolio) are not as impactful as might be thought. In scenarios where the total expense ratio of the fund portfolio (including advisor fee) is as much as 50 basis points per year lower than the total expense of the variable annuity (including sub-account expenses), the annuity is generally competitive in results.
4. The greater the growth rate assumed, the better the annuity performed (vis-a-vis the fund portfolio).
5. If the variable annuity contains a guaranteed living benefit rider, the paradigm changes. Comparing one investment with insurance features and insurance cost with another that offers no such insurance (and assesses no such cost) is daunting. One “quick and dirty” method for assessing whether such an insurance feature is “worth it” to the client is to ask that client if he or she would favor the investment alternative (e.g.: a mutual fund) if it offered the same protection. Most will respond with, “Sure, why wouldn’t I?” If we then ask if he or she would be willing to give up X percent (the cost of the annuity insurance feature) of the fund account value each year, whether a profit was earned that year or not, in order to have that feature, we may get a feeling for the “relative worth” of that annuity rider to that client.
Conclusion
Annuities are not simple things. Their provisions are often confusing (sometimes, so confusing that even “annuity experts” cannot make sense of them). Their taxation is complex and sometimes unclear. But annuities are not rocket science. They can be understood and evaluated, provided one is willing to look beyond “popular wisdom” and subject one’s own criteria and assumptions to the same level of scrutiny that one intends to apply to those annuities.
(author bio)
John L. Olsen, CLU. ChFC, AEP, is principal of Olsen Financial Group in Kirkwood, Mo., and co-author of The Annuity Advisor, now in its second edition. Olsen speaks frequently to estate planning lawyers and other financial professionals on the topic of annuities and annuity taxation.
Contact him at jolsen02@.
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[i] A “deferred annuity” is a contract in which “annuity income” (in the form of payments under a chosen annuity payout option) will not be received immediately (i.e.: during the first contract year).
[ii] The term “fixed”, in “fixed annuity”, refers to the fact that contract value is stated in terms of units of a fixed value (for contracts issued in the U.S. that unit is U.S. dollars), rather than units the value of which can change in value over time. It does not, as is sometimes supposed, refer to the nature of the interest rate credited.
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