August 1, 2005
(Smartmoney.com)
- VARIABLE
ANNUITIES
are sold more
aggressively
than fake Gucci
handbags on
the streets
of New York
City. Thanks
in part to commissions
around 5%, sales
of variable
annuities have
soared over
the past decade.
But popularity
is no indicator
of practicality.
The truth is,
annuities only
make sense for
a tiny fraction
of the population.
The rest of
us should be
buying plain
old mutual funds.
Of course, that's
not easy to
say to your
dark-suited
cousin who keeps
taking you out
for steak and
Lafitte-Rothschild
Bordeaux in
hopes that you
will sign on
the dotted line.
But, next time
he invites you,
you can bring
along this article.
Just make sure
he pays the
bill before
you give it
to him.
The
Basics
First, a primer.
A variable annuity
is basically
a tax-deferred
investment vehicle
that comes with
an insurance
contract, usually
designed to
protect you
from a loss
in capital.
Thanks to the
insurance wrapper,
earnings inside
the annuity
grow tax-deferred,
and the account
isn't subject
to annual contribution
limits like
those on other
tax-favored
vehicles like
IRAs and 401(k)s.
Typically you
can choose from
a menu of mutual
funds, which
in the variable
annuity world
are known as
"subaccounts."
Withdrawals
made after age
59 1/2 are taxed
as income. Earlier
withdrawals
are subject
to tax and a
10% penalty.
Variable annuities
can be immediate
or deferred.
With a deferred
annuity the
account grows
until you decide
it’s time
to make withdrawals.
And when that
time comes (which
should be after
age 59 1/2,
or you owe an
early withdrawal
penalty) you
can either annuitize
your payments
(which will
provide regular
payments over
a set amount
of time) or
you can withdraw
money as you
see fit.
Fees,
Fees and More
Fees
Variable annuities
are notorious
for the fees
they charge.
Indeed, the
average annual
expense on variable
annuity subaccounts
currently stands
at 2.08% of
assets, according
to Morningstar.
(This figure
includes fund
expenses plus
insurance expenses.)
The average
mutual fund,
on the other
hand, charges
just 1.38%.
Unfortunately,
variable annuity
fees don't stop
there. Many
variable annuities
also have loads
on their subaccounts,
surrender charges
for selling
within, say,
seven years
and an annual
contract charge
of about $37.
What
Death Benefit?
The death benefit
basically guarantees
that your account
will hold a
certain value
should you die
before the annuity
payments begin.
With basic accounts,
this typically
means that your
beneficiary
will at least
receive the
total amount
invested —
even if the
account has
lost money.
For an added
fee, this figure
can be periodically
"stepped-up"
or earn a small
amount of interest.
(If you opt
not to annuitize,
then the death
benefit typically
expires at a
certain age,
often around
75 years old.)
Well, given
the fact that
stocks have
returned an
average of 12%
annually (assuming
dividends are
reinvested)
from 1926 to
2004, according
to the Center
for Research
in Security
Prices, over
the long haul
you need this
insurance about
as much as a
duck needs a
paddle to swim.
OK, investors
who bought annuities
and then died
within the next
two months probably
got their money's
worth. But currently
only three out
of every 1,000
variable annuities
are surrendered
due to death
or disabilities,
according to
Limra International,
an insurance-industry
research group.
And this report
doesn’t
even measure
whether those
four accounts
were made whole
by the death
benefit!
The price of
this questionable
feature: an
annual 1.03%,
according to
Morningstar.
Surrender
Fees
Another problem
with most variable
annuities is
that your money
is often locked
up for several
years —
typically five.
Trying to withdraw
funds during
this time will
result in huge
fines. These
fees typically
decrease as
the years tick
by. For example,
you might be
charged a 7%
surrender fee
for a withdrawal
during your
first year of
ownership. After
seven years,
however, that
could be just
1%. The average
fee is a steep
6.3%, according
to Morningstar.
Early
Withdrawal Penalty
As with most
retirement accounts,
if you withdraw
funds before
age 59 1/2,
you'll be hit
with a 10% early
withdrawal tax
penalty.
The
Taxes
Gains in variable
annuities are
taxed at ordinary
income tax rates,
which go as
high as 35%.
For most investors,
that's a whole
lot higher than
the maximum
15% rate they
now pay on their
long-term mutual
fund gains and
dividend income.
And that tax
difference can
easily eat up
the advantage
of an annuity's
tax-free compounding.
"You’re
generally going
to have to wait
15 to 20 years
before these
suckers become
more tax efficient
than a mutual
fund,"
says CFP Dee
Lee of Harvard,
Mass.
Residents of
California,
Florida, Maine,
Nevada, South
Dakota, West
Virginia and
Wyoming and
Puerto Rico
pay even more
taxes —
an additional
1% to 3.5% tax
on nonqualified
variable annuity
accounts. (That
is, accounts
that are not
purchased within
an IRS-approved
retirement plan
like a 401(k),
403(b) or IRA.)
Some additional
states also
add a tax for
variable annuities
purchased within
a qualified
account.
The
World's Lousiest
Estate Planning
Vehicle
There's no getting
around the income
tax due on annuities.
In fact, if
you die with
money remaining
in your annuity,
your beneficiary
will inherit
all the taxes
that you have
deferred. Compare
this to a mutual
fund, whose
basis is stepped-up
at death. In
that case, your
beneficiary
would owe no
taxes on the
gains. Both
types of accounts
— annuities
and mutual funds
— are
liable for federal
estate taxes
on anything
over the federal
estate tax exemption
($1.5 million
for 2004 and
2005).
Switch
to a Low-Fee
Variable Annuity
Now, if you've
read all this
and still want
to buy an annuity,
do yourself
a favor and
buy one with
low costs and
good investment
options. These
are available
from mutual
fund companies
like Vanguard2
(average total
expenses, 0.67%,
including mortality
and expense
risk charges)
and T. Rowe
Price3 (0.79%
average mutual
fund expenses,
plus an additional
0.55% mortality
and expense
risk charge).
Investors who
already own
run-of-the-mill
high-priced
annuities should
consider a tax-free
transfer —
called a 1035
exchange —
to a better
quality, low-fee
annuity. Just
be sure to confirm
that your surrender
charges have
expired before
you make the
switch.
Source: Smartmoney.com
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