Tax-Shelter Tango: Keep Your IRA

Over the past decade, assets held in variable annuity contracts have increased rapidly, to more than $900 billion — due to a combination of deceptively clever marketing and the sales efforts of agents motivated by high commissions.

Annuities are marketed as safe investments and also as tax shelters, similar to individual retirement accounts, or IRAs. Basing their sales presentations on that presumed safety and tax shelter, agents can generate commissions that range from 4% to 6% of the customer’s investment. However, variable annuities generally make poor tax shelters, and can be very poor investments, to boot.

In a recent case, a broker recommended that a customer liquidate his $700,000 IRA and use the cash to buy an annuity, which would have generated an immediate commission of $30,000. (When he understood this cost, the customer declined the annuity.)

Now, understandably, the average customer won’t even try to read the annuity prospectus’ 100 or more pages of complex and impenetrable terminology. But here are the principal features of a typical variable-annuity contract you should know about: A variable annuity is an insurance contract that permits deferral of income tax on investments.

As with an IRA, interest, dividends and capital gains are tax-free until withdrawn by the annuity’s holder. Withdrawals from an annuity beginning after age 59 are subject to federal and state income tax. Withdrawals before age 59 are subject to an additional 10% federal tax, and, in some states, to a similar state tax, although the rates vary.

Most annuities provide for a charge in the event that the contract holder withdraws his money within the first few years. The withdrawal charge is generally 6% to 9% of the amount invested. Annuity sales agents receive an immediate commission, equal to around 70% of the withdrawal charge.

The sales presentation, verbal and written, asserts that the withdrawal charge decreases gradually to zero, typically over four to nine years. However, contrary to this assertion, regardless of how long a customer delays withdrawal of funds from the annuity, the costs paid to the insurance company will be more than the amount of the initial sales charge.

In addition, such payments to the insurance company will accumulate as long as the customer continues the annuity. For example, assume typical annuity expenses of 3% per annum, plus a withdrawal charge of 6%, reducing to 5% after one year, 4% after two years, 3% after three years, and zero thereafter. Adding each year’s annual expense to the withdrawal charge, the customer will incur cumulative expense of at least 6% upon exiting the annuity in the first year, or 8% in the second year, 10% in the third year and 12% in the fourth year, with the expenses mounting thereafter by an additional 3% per year.

Annuity customers pay a variety of annually recurring expenses, including mortality expense (for the cost of a death benefit), distribution fees, administration fees, investment fees and fees for optional extra features (such as, for example, a contractual right to a fixed rate of return). The total of these fees range from 2.4% a year to more than 4%, with 3% being the average.

These expenses are far greater, and therefore the ultimate returns are far lower, than the expenses and returns of investing in a low-cost, no-load mutual fund.

As a case in point, with one annuity that recently came to my attention, investing in an S&P 500 index fund through the annuity would entail annual expense that was at least 2.2% to 2.5% per annum higher than a no-load S&P 500 index mutual fund. Due to these extra expenses, over 10 to 20 years, the ultimate value of the annuity would be 25% to 60% lower than the value of the same investment in a mutual fund.

Gains in variable annuities are taxed upon withdrawal at ordinary income-tax rates — which go as high as 35% federally, compared to the current federal maximum 15% rate on dividends and long-term capital gains. Accordingly, the tax shelter of an annuity is temporary, one might even say illusory.

So for many investors — taking into account the higher expenses of annuities and their higher ultimate tax rates on investment gains — the cost of variable annuities is far higher than those for direct investment in stocks or equity mutual funds. Using variable annuities to invest in stock funds assumes all the risks of the stock market, plus the greater expenses of annuities that magnify losses.

Annuity customers may opt for “principal guarantees” at added cost. A typical provision of this sort allows annual withdrawals of 5% of the initial investment over 20 years, with a guarantee that, after 20 years, the insurance company would return the original investment — less all amounts previously withdrawn.

Therefore, over the 20 years, the investor would recover only his original principal, without any investment earnings. One could do far better in a money-market fund or bank savings account.

Another typical variable-annuity selling point is the option to convert to a fixed annuity with a “guaranteed” return, where there is no investment risk other than the solvency of the insurance company. The guaranteed rate of return for such fixed annuities is now around 3%, and historically has been about the same as short-term interest rates.

Annuities are “insured” in that the insurance company agrees to pay on the death of the customer an amount equal to the difference between the principal sum invested and any decreased value of the investments within the annuity. For example, in the case of a $100,000 investment worth only $80,000 at time of death, the insurance company pays an extra $20,000 to bring the total back to $100,000. This feature typically is paid for by an extra annual charge more than 10 times higher than the value of the death benefit.

In order to understand fully what an annuity contract costs and offers, one must contrast the agent’s sales pitch with the disclosures in the legally mandated offering prospectus. Buried in every prospectus, for instance, is a legally-mandated disclosure that no one should invest IRA money in an annuity for tax shelter, because funds in an individual retirement account already are tax-sheltered. Nevertheless, more than 50% of funds now in variable annuities have been transferred from IRAs and other tax-sheltered vehicles, presumably at the urging of a sales agent. The enormous pool of retirement funds is a tempting target for agents seeking fat commissions.

Once a customer buys into an annuity, there is a psychological lock-in effect, owing to the twin deterrents of the withdrawal charge and the penalty tax on withdrawals before age 59. But neither should be an impediment to exiting an annuity.

The withdrawal charge is the least of the long-term costs of the annuity. The longer the customer stays in the annuity, the greater the cost.

The tax costs of premature withdrawal can be avoided, in the case of money originally transferred from an IRA, by retransferring the money into another IRA. With respect to non-IRA money, the premature withdrawal tax is assessed only against profits — not the principal amount invested — and could well be considered a necessary price to extricate oneself from the annuity and its perpetually high costs.

Bookmark the permalink.