Uncle Sam wants us to save for retirement because the average Social Security payment of $1,461 just isn’t going to cut it on its own. That’s why annuities have special features and tax benefits to protect and grow retirement assets. Of course, nothing in the investment world is free and these features come at a cost. And they can be more than just a bit confusing.
Independent insurance agents are absolute experts when it comes to confusing puzzles like these, and their job is to simplify the process. They’ll help guide you through all your options, weigh the good and the bad, and even see you through it all from start to signature. It’s a whole lot easier.
So here they are, the top features of variable annuities.
First Things First — What Are Variable Annuities?
Variable Annuities are policies issued by insurance companies. The annuity owner receives regular guaranteed income for life, or for an agreed-upon number of years. Your annuity contract begins by making either a single payment or a series of payments.
Variable annuities can be deferred or immediate, and qualified or nonqualified.
- Deferred variable annuities accumulate money for a period of time before the policy pays income.
- Immediate variable annuities pay income right away.
- Deferred variable annuities accumulate money in investments selected by the owner called subaccounts. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They’re not guaranteed.
- Indexed variable annuities offer partial protection from market losses and accumulate money by tracking a market index, like the S&P 500.
- Qualified variable annuities are part of a pension plan or IRA. They are purchased with before-tax dollars.
- Nonqualified annuities are personally owned and paid for with after-tax dollars.
- Group variable annuities were created by life insurance companies as a vehicle to administer 401k plans. Group annuities are often used for small- and medium-sized plans.
Tax Features of Variable Annuities
Tax rules for variable annuities (or anything else) aren't simple. That's a fact. But the big picture is if you don't pay taxes on the money going in, you pay taxes on the money coming out.
Variable Annuities are tax-deferred. Unlike mutual funds, capital gains and dividends from the variable annuity subaccounts aren't included in taxable income. What that means for retirement savings is that instead of Uncle Sam getting the tax money, it stays in your account and continues to grow.
Transfers between variable annuity subaccounts aren't taxable. So if you decide to sell one kind of investment to buy another, you don’t pay taxes. For investors who change their portfolio holdings regularly, that's an important feature.
Some types of income that you can receive from an annuity, an annuity option, is partly taxable. And unlike IRAs or pension plans, there are no contribution limits for nonqualified variable annuities.
The Bad News
Variable annuities aren't eligible for the lower capital gains rate. They're taxed as ordinary income. Any money that you take out before age 59 1/2 will generally result in a 10% penalty tax. Withdrawals or loans from a nonqualified variable annuity are taxed as gain first.
That means that the money is fully taxable until all of the growth in the account is taken out. Income from an annuity option is partially taxable. The amount of the annuity payment that is considered principal is excluded from taxable income. Surrenders are taxed based on the surrender value minus total purchase payments.
All money received from a qualified variable annuity is 100% taxable at ordinary income tax rates. Income from Roth qualified annuities is tax-free.
So remember — if you didn't pay tax on the money going in, you pay tax on the money coming out.
Tax Treatment of Variable Annuities
|Contributions||After tax. Unlimited.||Pre-tax. Limits for IRAs and qualified plans apply.||After-tax. Limits for IRAs and qualified plans apply.|
|Growth, capital gains, and dividends||Tax-deferred.||Tax-deferred.||Tax-deferred.|
|Surrender||Gain is taxed at ordinary rates.||All proceeds taxable.||Tax-free.|
|Annuity income||Partially taxable at ordinary rates.||100% taxable at ordinary rates.||Tax-free.|
|Withdrawals||Withdrawals are gain first. Gain is taxed at ordinary rates.||100% taxable at ordinary rates.||Tax-free.|
|Loans||Loans are considered withdrawals. Gain first is taxed at ordinary rates.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in five years.||IRA loans not permitted. Pension plans may have exceptions for home purchase and loans repaid in five years.|
|Death benefits||Gain is taxed at ordinary rates. Proceeds will be taxed as "gain first."||Rules for inherited traditional IRAs and qualified plans apply.||Rules for inherited Roth IRAs and plans apply.|
|Sales||Proceeds in excess of basis taxed at ordinary rates.||N/A||N/A|
|Penalties||10% for withdrawals before age 59 1/2.||10% for withdrawals before age 59 1/2.||10% for withdrawals before age 59 1/2. Penalty for withdrawals prior to end of the fifth year.|
Income from annuities come in two flavors, annuity options and withdrawals. Annuity options guarantee income for life or for a period of years, but there is no access to principle. What that means is you pay the insurance company to guarantee an income no matter how long you live. Withdrawals are just that, removing money from the variable annuity account value.
Living benefits are a feature of variable annuities that can guarantee a minimum amount of lifetime income regardless of how the market performs. The most common living benefit is the guaranteed lifetime withdrawal benefit or GLWB. The great thing about living benefits is that you get the higher of the minimum income, and the income from your account.
The chart below is a summary of variable annuity income features.
Guaranteed Income Options
|During lifetime||At death||Advantages||Disadvantages|
|Life||Pays income for annuitants’s life.||None.||Highest income. Partly taxable.||No refund of unused principle.|
|Life and 10 years certain||Pays income for life. Not less than 10 years.||Balance if death occurs before the end of 10 years.||Protection for beneficiaries. Partly taxable.||Lower Income.|
|Life And 20 years certain||Pays income for life. Not less than 20 years.||Balance if death occurs before the end of 20 years.||Protection for beneficiaries. Partly taxable.||Lower Income.|
|Life with cash refund||Pays income for life. Payments are at least specified refund amount.||Balance of refund amount.||Protection for beneficiaries. Partly taxable.||Lower Income.|
|Period certain||Pays Income for a specified number of years.||Balance of payments.||Useful for certain planning purposes.||Outliving income.|
|Joint and survivor 100%||Pays income for longer of two lives.||No further payments at second death.||Surviving spouse continues to receive income for life. Partly taxable.||Lower Income.|
|Guaranteed lifetime withdrawal benefit single life||Pays income for annuitant’s life.||Balance of account.||Access to account values, death benefit.||Income taxed as withdrawals.|
|Guaranteed lifetime withdrawal joint life||Pays income for lifetimes of annuitant and second life.||Balance of account at second death.||Access to account, death benefit.||Income taxed as withdrawals.|
A benefit base is how the insurance company figures out how much income or benefit you should receive. The initial benefits base is the purchase payment. The benefit base increases by the higher of the actual account value, or a percentage increase of the previous benefit base. Each time the benefit is recalculated, it is "locked in" and used as the new benefit base.
When you have a GLWB, you don’t exchange your account value for income. You receive income from the higher of the benefit base, or the account value. Income from a GLWB is taxed as a withdrawal.
Principle Protection Features
Variable annuities have features to protect principal from down markets. Guaranteed minimum accumulation benefits guarantee a minimum account value regardless of investment performance. The minimum is usually 100% of the purchase payments after a 7-10 year holding period.
Some variable annuities, called indexed variable annuities, offer investors downside protection. You can choose from a selection of financial indices like the S&P 500, MSCI, or Russell 3000. Each selection offers a “downside” and an “upside”.
The downside is how far down your account can go without loss. A 10% downside means the insurance company covers losses in your account up to 10%. The upside is the limit on how far up your account can go. An 10% cap upside means your account can grow a maximum of 10% in a year regardless of how well the index performs. The insurance company keeps the balance.
Death Benefit Features
The standard death benefit of a variable annuity is the greater of the account value and the original purchase payment. Some life insurance companies offer death benefits that step up or increase based on a formula.
The formula can be the greater of the purchase payments accumulated at an interest rate and the account value. The formula can also be based on the highest previous account value.
Creditor Protection Features
Some types of assets can be protected from lawsuit judgments or bankruptcy. For some people who may be more likely to be sued (think doctors, corporate executives, etc.), protecting their assets from creditors can be a very important reason to get an annuity.
Most states offer annuities some form of creditor protection. Some states protect all of the annuity proceeds from creditors where others just protect the beneficiaries' interest.
So, What Does All This Cost?
The insurance company charges fees and expenses for the features of variable annuities. Fees and expenses can range from .6% for low cost options to 4% and more to include rider options. The chart below is a summary.
|Mortality and expense||1.25% of the account value.||Cost of providing insurance.|
|Management fees||.25% - 2% of subaccount value.||Fees paid to subaccount investment managers.|
|Administrative fees||$25.00 - $50.00 per transaction.||Cost of transactions and record keeping.|
|Surrender charges||7%, 6, 5, 4, 3, 2, 1, 0.||Charge declines over a period of years usually 5 - 7. Withdrawals up to 10% of the account value are usually free of surrender charges.|
|GMIB, GLWB||1% and up of benefit base.||Charges for guaranteed minimum income riders.|
|GMAB||1.4% and up.||Charge for optional guaranteed minimum accumulation benefit.|
|Enhanced death benefits||.65% and up.||Charges for stepped up death benefit option.|
|Premium tax||Premium based.||8 states charge a premium tax: CA, FL, ME, NV, PR, SD, WV, WY.|
What's So Great About an Independent Insurance Agent?
Insurance policies are complex, and searching through options can be confusing, time consuming, and frustrating. An independent insurance agent's role is to simplify the process.
They will make sure you get the right coverage that meets your unique needs and will break down all the jargon so that you understand exactly what you're getting.
Contact a local independent insurance agent. They can help you decide if a variable annuity is right for you.
TrustedChoice.com Article | Reviewed by Neel Lane
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The Advisor's guide to variable annuities John Olsen
SEC Guide To Variable Annuities
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NAIC Deferred annuity buyer's guide
SSA.gov average benefits payable 2018