Why own Variable Annuities? Frequently you see the word “guarantee” associated with Variable Annuities (VA). What does that mean?

The typical VA acts as a tax deferred tax shelter, like an IRA. Unlike an IRA, anyone can open any sized (e.g.: $1,000 or $1 million) Variable Annuity, independent of his or her income, age or employment status. This is quite attractive for someone looking to shelter income from taxation, particularly for those that cannot achieve their goal with an IRA.

Traditional IRAs can only be established by those under the age of 70 ½ and those (or the spouse of those, if married filing jointly) who receive income or alimony. An IRA has contributions limits, which limit the tax sheltering benefits.


In almost all cases a variable annuity (VA) is a form of life insurance. The traditional insurance salesperson markets the variable annuity as a way to safely invest in the financial markets, without risking your principal. We all know there is no such thing as a free lunch inside or outside the world of finance. The insurance salesperson will often tell you, you cannot earn less than 6% or 7% on the investment.


Inherent in most VA policies are two components, an investment component and an insurance component. The investment component offers a choice of investments similar to mutual funds, called sub-accounts. It is the insurance component that is hard to understand.


The insurance component of a VA includes a death benefit. The death benefit “guarantees” the beneficiary will receive the greater of the: value of the VA at death, or the total of all contributions.
Here is an example of an investor, whose portfolio was 100% invested in a stock sub-account of a variable annuity. Assuming the investor invested $5,000 each year for 20 years, contributions would total $100,000. If the average net return per year were 7%, the Variable Annuity would be worth approximately $205,000 at the end of 20 years.

One evening this same Variable Annuity (VA) buyer learns the stock market has declined 50% in that day. This buyer realizes his VA is worth $102,500, has a stroke and dies. His beneficiary would receive the greater of $102,500 or $100,000. In this case the beneficiary would receive $102,500.
So, where was the death benefit? There was NO death benefit. The only time the beneficiary receives a death benefit is when the policy value falls below the total value of contributions made AND the investor dies.

Well, at least the investor did not have to pay any expenses for a death benefit they did not receive, right? Wrong. In most Variable Annuities the policies are mortality and expense charges, called M&E charges. The “E”, or expense charge, represents the administrative component of the M&E. The “M”, or mortality charge, represents the life insurance component of M&E.

The industry average annual annuity charge for non-group open variable annuity contracts was 1.37%. In addition to M&E charges, most VA policies have surrender costs. These are penalties assessed on the policy if the investor moves the policy before the surrender period ends. Some insurance companies offer annuities with 10-12 surrender periods and 12%-15% surrender charges – something has to pay for the “Insurance Agents” commission. Of course, this is in addition to all underlying costs of the sub-accounts (similar to expense ratios inside all mutual funds).

A few companies offer no-load, low cost, no surrender penalty VA policies. An investor can transfer from one annuity to another annuity without tax consequences, like an IRA transfer, but it must be handled with care.


Like an IRA transfer, the transfer of a VA policy, should be conducted on a custodian-to-custodian basis. The transfer qualifies as a tax-free transfer if conducted using Internal Revenue Code 1035. A “1035 Exchange”, as it is commonly referred to as, is the transfer of one insurance policy into another insurance policy. Handled incorrectly, and the investor could have a taxable distribution and hefty tax bill to boot.


Guarantee? Insurance companies have been very quick to highlight the “guarantee” in their VA policies. A word of caution on that “guarantee”: it is not a guarantee by the U.S. Federal Government. Unlike FDIC, the guarantee provided by an insurance company is a promise by an insurance company that it will pay. Some investors who buy their variable annuities from bank are like-wise fooled. The bank does not guarantee the annuity. If the insurance company goes out of business, you cannot rely on the bank or the FDIC to pay you. This applies to all annuities. My Mother recently called me from a bank. By the way, my Mother belongs to Phi Beta Kappa and is intelligent. She was telling me how the bank manager was (helping her) get out of her CDs, where she pays taxes on the interest. She was being switched to FIXED Annuities. I asked her to ask the bank manager what were the guaranteed in the Fixed Annuities, what were the surrender charges if she wanted to cancel, what taxes would she have to pay if when she cashed the annuities in. A few minutes later my mother got back on the phone that the bank manager not only could not answer the questions, but now the manager was too busy to help her. In case you are wondering, had my Mother make the mistake of buying an annuity from the bank, there would have been substantial sales charges, substantial surrender charges and substantial taxes due when my Mother finally cashed the annuity. What should my Mother do? That is like asking me to prescribe without knowing the symptoms. That is a topic for another article. You may want to look at www.taxlibrary.us to read some very informative articles on point.


Buyer Beware! By the way, your typical Insurance Agent gets paid by commission therefore you have to be very careful. If you do the exchange wrong tax consequences will result.


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Lance Wallach, CLU, ChFC, the National Society of Accountants Speaker of the Year, speaks and writes extensively about retirement plans, Circular 230 problems and tax reduction strategies. He speaks at more than 40 conventions annually, writes for over 50 publications, is quoted regularly in the press, and has written numerous best-selling AICPA books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Business Hot Spots. He does extensive expert witness work and has never lost a case.

Contact Lance Wallach at 516.938.5007 or visit www.taxlibrary.us or http://www.taxaudit419.com/


The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.