In last week's
column, I told you I was reconsidering my negative opinion about variable annuities. The rap on them is that they're too expensive and that the tax advantages are less than meets the eye.
But research by John Huggard, a
North Carolina State University
professor who is also an estate-planning lawyer in Raleigh, N.C., suggests that in some cases annuities are a better deal than mutual funds. Yes, fees are higher for annuities, but Huggard says capital-gains taxes on distributions can be a much bigger burden for investors in mutual funds.
In a recent article in
Financial Planning Magazine
, Huggard sketched this scenario:
Assume two investors, Andy and Betty, are both in the same income tax bracket and 25 years old. Assume further that Andy buys $3,000 worth of a mutual fund each year with a high turnover ratio. Annually, Betty buys $3,000 worth of the same mutual fund through a variable annuity. Both investments increase at the annual rate of 15%. Who has the tax advantage? The answer is Betty, the variable annuity owner. ... By applying a 30% combined state and federal income tax burden to capital-gains distributions and dividends, Andy's mutual fund holdings will be worth $600,000 in 30 years while Betty's variable annuity will grow to approximately $1.5 million during the same period. ... Assuming the additional cost of the annuity reduces Betty's annual return to 14%, she would still have $1.22 million.
But what about when money is taken out of an annuity? Earnings are taxed at your ordinary income rate, while gains on mutual fund shares held more than one year are taxed at the lower capital-gains rate.
Critics assume people will pay taxes at a 28% rate or more on money taken out of a variable annuity (vs. 20% for capital gains). But that is not always true. We still have graduated tax brackets, and the first bracket is 15%. Married couples do not hit the 28% bracket until they have $43,050 of taxable income, and only income above that threshold is taxed at the higher rate. For singles, the threshold is $25,750.
If a husband and wife have a gross income of $115,700 and take only the standard deduction and personal exemptions, they would have a taxable income of $101,300. The federal income tax would be about $22,767. That amounts to about 22% of taxable income, or just slightly above the capital-gains rate. As long as distributions from an annuity do not push the overall income over $115,700, the tax rate is comparable.
Anybody who is properly managing a mutual funds portfolio will make occasional changes. Whenever you want to change funds in your portfolio, it generally constitutes a sale and is therefore a taxable event. Selling funds within an annuity is not a taxable event. Since no tax is paid, that leaves more money in the annuity to be invested.
The same concept applies if you want to change annuity companies. You can do what is called a Section 1035 tax-free exchange from one company's annuity to another's without triggering a tax. On the other hand, you can't change mutual fund companies without triggering a tax.
, one of the mega-accounting firms, released a report earlier this year comparing variable annuities and mutual funds. The report concluded: "Long-term savers generally receive higher aftertax payouts through variable annuity investments relative to similar investments in mutual funds."
There are other advantages to annuities. For example, income from an annuity doesn't count when determining the taxability of Social Security income.
One supposed drawback is that proceeds of a variable annuity do not receive a "step-up" in basis when someone dies. For instance, if a $100,000 nonannuity investment grew to $200,000, the tax basis would be adjusted upward to $200,000 at death. If the heirs were to sell the assets at that point, there would be no income tax. An annuity does not get the step-up in the tax basis, and ordinary tax has to be paid on the gain.
But Huggard argues that the greater long-term return of a variable annuity can more than compensate for this tax burden.
I believe there is a place for variable annuities. They could be considered for part of a portfolio under the following circumstances:
- When targeted for retirement years (after age 59 1/2), but held for at least 10 years by an investor who expects to be in the same or lower income tax bracket at retirement.
When investors have maxed out contributions to 401(k)s, IRAs, 403(b)s and the like.
When investors plan to take the money out over a few years, not in a lump sum.
When somebody can benefit from the variable annuity's guaranteed death benefit.
Thanks for so many great emails.
wrote: "My friend was given 10 years to live, max. He had two children and a wife. The death benefit was the most enticing aspect. He wanted growth but no risk. He invested $200,000 aggressively in the annuity. Now it's worth $500,000. Even if the value goes to $400,000 at death, his family is guaranteed $500,000 at the minimum."
added: "People are less inclined to tinker with their annuities, so they do better."
Have a great week.
Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at