Taxes On Variable Annuities Can Croak Your Estate

Few financial products have been marketed more successfully. Yet few financial products are so useless.

The topic is variable annuities, the product that can double the cost of investing in a mutual fund by giving it a life insurance wrapper while making it hopelessly expensive to change your mind and take your money back. Worse, few products offer tax deferral so skillfully while ignoring one of the biggest tax breaks most people will ever get—escaping the tax on all unrealized capital gains when you die. Let me show you just how expensive deferring current taxes can be.

There are now some 151 variable annuity sub accounts (funds) that have 15-year track records, up from 121 at the end of 1998. Of that number, 35 are money market funds, 40 are fixed income funds, and 76 are equity funds. While the money market and fixed income funds are modestly popular, few financial planners advocate such investments because the fee burden is too high— why pay 2 percent in annual expenses to gain tax deferral on a 5 percent return?

That leaves us with 75 equity fund sub-accounts that can offer us the high returns of equities and the benefits of tax deferral. The rank ordered list below shows the top 30 performers over the last 15 years. It also includes the performance of the Vanguard 500 Index fund over the same period, bought in a taxable account and paying taxes, as they were due in each year. As you can see, the simple, no-load, low-expense index fund was 12^th on the list, indicating that it would have ranked in the top 16 percent of all 75 variable annuity equity sub accounts.

In other words, for a one in six shot at doing better, you had to encumber your money with early withdrawal penalties and extra fees.

Top 30 Equity Variable Annuity Sub-Account vs. Vanguard 500 Index fund

Source: Morningstar Principia Pro, September 31, 1999 data

But that isn’t the whole story. At the end of the 15 years your cost basis for any of the variable annuities is $10,000— exactly what you paid in. Anything over that is taxable as ordinary income when it is removed. The index fund investment, however, has been paying taxes on dividends and capital gains all along. As a consequence, your cost basis has risen to $23,521 after 15 years. Better still; since all the accumulated gains are capital gains, taxable at 20 percent, the tax burden will be smaller. If the investments were liquidated, the after-tax value of the index investment would be $79,689.

Its ranking would rise to 4^th, beating 72 of the 75 Variable annuity accounts.

Few people, however, would defer taxes for 15 years just for the joy of paying it all in a big check at the end. The reasonable thing to do is to make annual withdrawals, say 10 percent a year.

What happens then? The Index investment gets even better.

You take $9,373 out of your index fund. If you do it on an average cost basis, $2,352 will be non-taxable return of capital in the first year and $7,021 will be realized capital gains, staxed at 20 percent. After that you’ll have $7,969 to spend.

Now try the same trick with the variable annuity. Taxed on a LIFO (last in, first out) basis, every dime withdrawn is taxed. Worse, it will be taxed as ordinary income. Say, 31 percent. As a consequence, the index fund will rise to fourth place, beaten by only 3 of 75 variable annuity funds because the variable annuities have a tax disadvantage when you take the money out.

Finally, let’s consider what some have referred to as “our last incentive to die”, the step up of asset values at death. If you die before getting to use your variable annuity money, taxes will be due on every dime of accumulated tax-deferred income. The entire $14,000 tax liability in your index fund, however, will disappear as the cost basis of the investment is “stepped up” to its value at death. As a result, your heirs would receive $93,731, before estate taxes.

Only one variable annuity fund would deliver more money after income taxes to your heirs. Yes, you read that right. Only one of the 75 variable annuity equity funds would have been better for your estate than a simple index fund.

Not planning on dying? No one is. But the very thing that makes variable annuities attractive— long-term tax deferral— means that they will backfire for many investors.

Bottom line: Keep it simple; keep it cheap. You’ll be better off now, later, and hereafter.

Want to read more? Check “Variable Annuity Watch” on my website at: www.scottburns.com/readers/wwvareader.htm.

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: Pexels-Mikhail Nilov

(c) A. M. Universal, 1999