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Variable annuities

March 14, 2017

Variable annuities, or single payment deferred annuities, provide a tax-sheltered mechanism that allows funds to grow without any tax payments until the income is actually withdrawn.

Variable annuities can be an appropriate investment where the need and intention is to accumulate as much of a capital base as possible to provide cash flow during retirement and possibly for the rest of the owner’s and, if requested, their spouse’s lives. Variable annuities can also include a death benefit for the original amount invested or some other amount. Variable annuities can be applicable for someone of limited means where a guaranteed cash flow is provided that they cannot outlive, as well as someone with a large portfolio that wants an anchor of a guaranteed cash flow and protection against asset decreases. Funds can be withdrawn as an annuity payable for the rest of the owner’s life, at varying amounts or percentages annually, or as a lump sum at any stage where there is a remaining balance. They are not liquid and are private contracts with an insurance company.

Variable annuities provide tax deferred asset accumulation. Income within the annuity is not taxed but is taxed as withdrawals are made. Upon a lump sum withdrawal all of the income will be taxed and possibly at higher rates since the income will consist of many years’ accumulation.

Some negatives of variable annuities is that the accumulation does not qualify for a step up in basis upon death, nor does it qualify for any type of tax-free rollover or stretched out withdrawal as an IRA would. This means that the entire income accumulation would definitely be taxed when withdrawn during life time or after the annuity owner’s death. If the funds are withdrawn before the owner attains age 59 ½, there is a 10% premature withdrawal penalty on any income. When funds are withdrawn part will be taxed and a part will be considered a tax free return of capital. Fees can be charged by the insurance company upon acquisition of the annuity, upon liquidation, or when withdrawals are made in excess or certain predefined amounts or percentages of the asset accumulation. All provisions are stated in the annuity contract.

An annuity is an insurance contract and as such is eligible for a Section 1035 tax free rollover into another similar insurance contract should that occasion arise. While variable annuities are not federally insured they are insured to certain limits by your state’s insurance guaranty fund. When investing, consider keeping the investment and eventual accumulation below those limits.

Variable annuities permit choices of underlying investments that could be for income, growth or a combination of the two. Regardless of the type of investments, all income would be taxed at ordinary rates – there are no capital gains or dividend rates. Furthermore there is no ability to contribute the annuity to a charity during lifetime and get a full deduction while avoiding the capital gains tax on the appreciation. If a charity is the beneficiary upon death, then the income taxes will be avoided.

For those using an investment manager, an advantage of a variable annuity is that it removes those funds from the assets under management pool subject to annual fees. There could be a fee when the annuity is purchased, but it is a onetime payment while the management fees are paid annually.

Variable annuities are complicated and need a thorough understanding of what they are, the benefits and costs and how they fit into an overall investment plan. Use this blog as a brief introduction.

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