I’ve written before about indexed annuities, one of the most expensive, abusive, unnecessary financial products known to man, but I’ve recently had a couple occasions to learn more about variable annuities, the confusingly-similarly-named product offered at lower cost by more reputable firms, like Vanguard and Fidelity.
Variable annuities are expensive
There are two expenses that go into a variable annuity: the wrap fee and the fee for the underlying funds your money is invested in.
For example, Vanguard charges 0.29% in annual administrative and “mortality and expense risk” fees, plus investment portfolio expense ratios ranging from 0.11% (Total International Stock Market Index Portfolio) to 0.42% (Growth Portfolio).
Meanwhile, Fidelity charges 0.25% in fees plus portfolio expense ratios between 0.10% (Fidelity VIP Index 500) and 1.54% (PIMCO VIT CommodityRealReturn Strategy).
Since you’re a sophisticated investor, say you combine the best of both worlds and invest only in the cheapest fund with each provider. You’ll pay 0.4% annually to invest in the total international stock market with Vanguard, and 0.35% annually to invest in the S&P 500 with Fidelity.
Is that a lot? Well, it’s over 3 times more expensive than buying Vanguard’s Total International Stock Index Fund Admiral Shares and almost 9 times more expensive than buying Vanguard 500 Admiral shares, but it’s not objectively very expensive, so if variable annuities offered tangible benefits, they wouldn’t have to be very valuable to make back that difference.
So, do they offer tangible benefits?
Variable annuities are not tax efficient
The first problem with variable annuities is they swap the extremely favorable tax treatment of capital gains and qualified dividends for the extremely unfavorable treatment of ordinary income. This happens in a fairly complicated way that I still don’t fully understand, but essentially withdrawals from variable annuities are done against an after-tax contribution portion (which is untaxed on withdrawal) and an earnings portion which is taxed as ordinary income, a bit like how non-qualified withdrawals from 529 plans work (except more complicated).
The advantage of this trade (capital gains for ordinary income) is theoretically that you can defer capital gains taxes during your high-earning years, when you might pay up to 23.8% on them, and then make withdrawals during your low-earning retirement years, when your marginal tax rate on ordinary income is lower.
If capital gains were taxed as ordinary income (as I would prefer), this argument would be airtight, and variable annuities would be a commonsense way to smooth your tax burden over a lifetime. People would use variable annuities instead of taxable brokerage accounts for all their savings in excess of qualified retirement accounts, paying less in capital gains taxes during their working years and more in ordinary income taxes during retirement.
The problem is that capital gains aren’t taxed as ordinary income: they’re taxed at preferential rates, and those preferential rates extend high up the income scale. The 23.8% rate I mentioned above is the highest rate paid on capital gains, while taxable income in excess of $82,500 is taxed at 24%, and rates only climb from there.
Between Social Security old age benefits and required minimum distributions from IRA’s and 401(k)’s, taking taxable withdrawals from a variable annuity can easily put someone’s taxable income in the range where they’re actually paying more on their gains than they would have if they’d simply held their investments in a taxable account and benefited from preferential capital gains tax treatment.
Variable annuities are terrible estate planning
When the owner of a taxable investment account dies, their heirs inherit their assets with a “stepped up” basis: the owner’s unrealized, untaxed capital gains receive a new, higher cost basis and those capital gains will never be taxed.
When a variable annuity is inherited, the account retains the distinction between contributions and earnings, and earnings will still be taxed on withdrawal at the heir’s ordinary income tax rate.
Heirs can either take a lump sum distribution of the account’s balance (potentially paying up to 37% of the earnings in taxes), or spread the distribution out over 5 years. In either case, rather than the owner saving money on taxes in retirement, the account’s gains are taxed at the likely higher tax rate of the inheritor.
The best case for variable annuities
I gather that I come across as a bit of a scold in this post, but I always try to find the good in everyone and in every financial product, so after a little bit of thinking, I came up with a perfectly reasonable use case for variable annuities.
Consider a high earner who knows she wants to retire early. Because she’s a high earner during her working years, she exclusively uses traditional IRA’s and 401(k)’s to reduce her taxable income. Likewise because she’s a high earner, she’ll pay 23.8% in taxes on any dividends and capital gains distributions during her working years for assets held in taxable accounts.
Instead, he contributes to variable annuities, perhaps splitting his contributions 50/50 between the lowest cost options at Vanguard and Fidelity (I don’t know why Fidelity doesn’t have a low-cost international stock portfolio. Or, rather, I do know why).
If she contributes, say, $50,000 per year to her variable annuities, compounding at 5% annually over 20 years, she’ll end up with $1.736 million, of which $1 million will be contributions and $736,000 will be earnings.
At age 59 1/2 (when variable annuity withdrawals become penalty-free), he gives two weeks notice and start withdrawing 9.1% of the balance per year, or $158,000, of which $91,000 will be tax-free contributions and $67,000 will be earnings taxed as ordinary income (this is not exactly how it works, but close enough). Assuming no other taxable income, he’d owe a nominal amount of tax on that amount.
Then, at age 70 she would file for her much higher Social Security old age benefit and at age 70 1/2 start collecting required minimum distributions from her traditional IRA and 401(k) accounts.
In other words, since delaying filing for Social Security is so lucrative, even someone retiring early should find a way to delay claiming their Social Security old age benefit as long as possible. If they have no earned income in retirement, then the relatively unfavorable tax treatment of variable annuity withdrawals is irrelevant, as long as their total taxes paid on withdrawals is lower than the capital gains tax payments they would have owed during their working years had the assets been held in a taxable account.
Best case at bottom is brilliant. I’ll bet fidelity and vangard would love to have you help them explain that. Would only apply to a few (and most of them probably use more traditional investment advisors.
Your “best case” is not correct. The only time that you can get part of your withdrawals tax-free as basis and the other part taxable as gains is if you annuitize the contract (agree to take a lifetime payment stream and surrender any access to the lump-sum value, although there are a few different payment methods you can choose), at which time the so-called exclusion ratio will determine the taxable and non-taxable portions. However, annuitizing the contract at age 59 1/2 would probably provide for a far lower withdrawal percentage than 9.1%.
Regular withdrawals from a variable annuity, as in your example, are taxed on a LIFO (last-in, first-out) basis. That means that your withdrawals will all come from the gains on the contract, and thus be fully taxable as ordinary income, until all the gains are exhausted. Once all the contract’s gains have been withdrawn, then withdrawals start coming from the basis and are tax-free.
Justin,
Thanks for clarifying that, I’ve seen a whole bunch of conflicting information so was trying to give my best gloss on the procedure as I understood it. It’s hard to figure out how the rules actually work without talking to a salesman, which I’m not willing to do.
So to achieve the effect I describe as the “best case” you’d need to annuitize at 59 1/2 with a 10-year (or 11-year, if you could find one) period certain annuity, and then the proportion of earnings and contributions would depend on the exclusion ratio? Is there any reason a 59 1/2 year old would not be able to do that?
—Indy
Indy,
Yes annuities are very confusing, and in your article you alluded to not totally understanding the taxation so I figured I’d help. 🙂
You could elect a payout option with period certain but that would reduce the annual payments even further. 10 year period certain just means that if the annuitant dies prior to 10 years of payments, the annuity will keep paying to the beneficiary until that 10 years is up. It does not mean that the annuity is paying you back your entire contract value over 10 years.
I’m a CFP(R) professional and I agree that a variable annuity is almost never the best investment option. And the fees you mentioned are definitely on the low end. With other companies the M&E charges are often much higher, plus with subaccount and any optional rider fees, fees can quickly get in the 3-4% range.
As you pointed, the commonly touted advantage is tax deferral but the issue is that at some point you or your beneficiaries are going to be taxed ordinary income on all the gains rather than capital gains tax like you could have received in other mutual funds/ETFs, etc.
Variable annuities do offer some asset protection. Perhaps the most logical use would be for a young doctor who earns a high income (already maxing our retirement plans) and can really use investments with tax deferral and asset protection. But still, not sure I would recommend an annuity even in that case.
I do think there is a much better use for indexed annuities, which I know you hate. Not everyone wants to trade options and plenty of retirees have more than enough money, and don’t care about getting the best returns, but simply want to protect a portion of their portfolio in a strategy that provides partial upside market potential with complete downside protection. In such cases, an indexed annuity can fit the bill and (if selecting the appropriate one) has no fees. The “cost” is the capped limited potential. But if someone was going to invest that money in bonds yielding 3% (which can decline in value) anyways and they can instead use an indexed annuity with total downside protection and, say, 5-6% upside potential per year, that can make sense.
Anyways, I hope this is helpful info. You produce a lot of thought-provoking info.
Justin,
I hadn’t thought about the idea of asset protection, I can see that being a possible advantage for someone with unlimited liability, I’ll need to look into that more.
Thanks for sharing your insight and expertise, and thanks for reading!
—Indy
You bet, keep up the good work!
“Wrapping my head around variable annuities” — As you discovered, there is nothing to wrap your ahead around. People are better off expending their brain molecules elsewhere. Except in a very few unlikely cases, variable annuities are terrible products, designed to make a nice commission for the broker selling them.