By: Investor Solutions, Inc.
Congress just landed a right hook on the face of variable annuity companies. The recent Jobs and Growth Tax Relief Reconciliation Act of 2003, reducing dividend tax and capital gains rates to 15%, infused fuel to an already heated debate on the value of owning annuities. Furthermore, President Bush’s new tax law, failed to give dividends paid on stocks held in annuity sub-accounts the same favorable treatment afforded to stocks held in mutual funds.
Many industry experts have long considered variable annuities to be sub standard products. High fees, embedded costs, inflexible surrender periods, and poor investment choices are some common traits that make most variable annuity products undesirable.
Annuity salespeople glorify the tax deferral feature of this product as a selling point. It’s true, during the life of the annuity, earnings and dividends are deferred until distribution. That’s a positive. But at distribution, the growth in the account is taxed at ordinary income rates as high as 35%! Compare that to a 15% tax on earnings outside of an annuity. Furthermore, contributions are not tax deductible and deposits are made with after tax dollars.
Distributions of earnings before age 59 ½ face an ever-stiffer 10% penalty on top of the 35% tax already imposed. Ouch! And from an estate planning perspective, annuities do not qualify for a step up in basis, unlike securities in taxable accounts.
If tax efficiency is what an investor seeks, why not consider and indexed mutual instead? Granted, unless you own it in a retirement account, there is no tax deferral as there is with an annuity. But by their nature, passive investment strategies generate very little in income and gains. And, if held over one year, the proceeds are taxed as long term gains.
No doubt the new tax law makes tax-deferred annuities less attractive. You now have to balance the benefit of tax deferral against converting gains that would otherwise be taxed at 15% into income taxed at ordinary rates. When you factor in other disadvantages – the upfront costs that often apply to these investments, the ongoing expenses and the possibility of surrender charges and early distribution tax penalty, annuities have to overcome huge obstacles.
While other tax deferred vehicles may be more practical, variable annuities may be appropriate in certain circumstances. One of the few legitimate uses for an annuity is asset protection. For example, in the state of Florida, annuities are protected from creditors under statutory law. A physician practicing medicine in the state may find variable annuities an indispensable component of their overall financial plan if all other asset protection strategies have been exhausted.
Ninety nine percent of annuity products being sold are garbage! Not all annuities are created equal. Most carry hefty surrender charges, unconscionable operating expenses, pay huge commissions and offer limited and unsatisfactory investment choices.
Steer clear of salespeople pimping annuities that, on top of their hefty commissions, generally cost investors an additional 2-3% in internal fund expenses. That’s creates a 2-3% drag on your profits every year! And watch for contingent deferred sales charges that attempt to cage you to the product for several years.
If you have exhausted every other investment opportunity and are still compelled to consider an annuity, there are only a handful of variable annuities worth mentioning. Check out the Vanguard annuity or the Peoples Life Advisors Edge Variable Annuity through Aegon. Both offer low operating expenses (between 0.40% and 0.65%) and rock bottom fund fees of 0.30% or less, no commissions, have no surrender period and provide a reasonable selection of global investment choices.
As with any other investment, if you are in a situation that warrants the need for an annuity, look for a product that has your best interest at heart (not the broker’s).