A recent FINRA investor alert gets right to the point: “The marketing efforts used by some variable annuity sellers deserve scrutiny—especially when seniors are the targeted investors.” As if these products weren’t complicated enough variable sales pitches are sometimes tailored to confuse. Others employee scare tactics and share false claims.
The FINRA alert Variable Annuities: Beyond the Hard Sell focuses on deferred variable annuities and distinguishes them from mutual funds by pointing to three basic features:
- Tax-deferred treatment of earnings.
- A death benefit.
- Annuity payout options that can provide guaranteed income for life.
All that sounds good and variable annuities can be appropriate investments – for some investors in particular circumstances. However investors must be aware of their restrictions and understand that substantial taxes and other charges may apply if money is withdrawn early. To quote the FINRA alert carefully read the prospectus to ensure you understand the terms. To that end I’d like to share FINRA’s advice on seven factors to evaluate:
Liquidity and Early Withdrawals: Many variable annuities assess surrender charges for withdrawals within a specified period which can be as long as six to eight years. Also any withdrawals before an investor reaches the age of 59 ½ are generally subject to a 10 percent tax penalty in addition to any gain being taxed as ordinary income.
Sales and Surrender Charges: Most variable annuities have a sales charge. Like class B shares of mutual funds many variable annuity shares typically do not charge a front-end sales charge but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example a surrender charge could start at 7 percent in the first year and decline by 1 percent per year until it reaches zero.
Fees and Expenses: In addition to sales and surrender charges variable annuities may impose a variety of fees and expenses when you invest in them such as mortality and expense risk charges administrative fees underlying fund expenses and charges for special features such as principal protection. These annual fees on variable annuities can reach 2 percent or more of the annuity’s value.
Taxes. While earnings in a variable annuity accrue on a tax-deferred basis—typically a big selling point—they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains but allow your contributions to reduce your current taxable income. That’s why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans.
Once you start withdrawing money from your variable annuity earnings (but not principal) will be taxed at the ordinary income rate rather than at the lower capital gains rates applied to investments in stocks bonds mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year.
Furthermore proceeds of most variable annuities do not receive a “step-up” in cost basis when the owner dies. Other types of investments such as stocks bonds and mutual funds do provide a step up in tax basis upon the owner’s death.
Bonus Credits. In an attempt to attract investors many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity generally ranging from 1 percent to 5 percent for each premium payment you make. Bonus credits however are usually not free. In order to fund them insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods.
Guarantees. Insurance companies issuing variable annuities provide a number of specific guarantees. For example they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations it happens. There are several credit rating agencies that rate a company’s financial strength. Information about these agencies can be found on the SEC’s website.
Variable Annuities within IRAs. Investing in a variable annuity within a tax-deferred account such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged a variable annuity will provide no additional tax savings. It will however increase the expense of the IRA while generating fees and commissions for the broker or salesperson. Also if the annuity is within a traditional (rather than a Roth) IRA the government requires that you start withdrawing income no later than the April 1 that follows your 70½ birthday regardless of any surrender charges the annuity might impose.
You can read the entire alert by clicking on the following link:  Click here.