It makes me both sad and mad to see how many individuals get conned into putting IRA and 401(k) money into a variable annuity. Variable annuities are a tax-deferred investment vehicle that come with an insurance contract, typically designed to protect you from a loss of principal. The earnings inside the annuity are allowed to grow tax-deferred and there are no annual contribution limits as there are with other tax-deferred investment vehicles such as IRAs and 401(k)s.
Wait, back up a moment... did I just write "as there are with other tax-deferred investment vehicles such as IRAs and 401(k)s"? Well, by golly I did didn't I. Well then why in the world would an insurance salesman want you to take your already tax-deferred money and put it into another tax-deferred investment vehicle? Is there some kind of double deferment thing happening here? NO
What's happening is the snake-oil (ahem) I mean variable annuity salesman is looking for a big pay day, anywhere from 5%-10% of the total amount of the money you put into the annuity. It's a bad deal for the investor, make no mistake. You gain nothing in improved tax treatment, yet variable annuities are expensive, running 2.44% per annum in annual expenses versus 1.32% for the average open-ended mutual fund, according to Morningstar. And that 2.44% doesn't take into account the additional commissions that are often paid out as ongoing fees. Oh, and there is the pesky little surrender fee designed to lock you into the variable annuity long enough for the insurance company to pay-off the guy who sold you on the idea in the first place. The typical surrender fee in the first year of a contract is a whopping 6%, dropping to a mere 1% in the seventh year.
And what's the big benefit of using a high-commission, high-expense variable annuity? Well the smooth talking salesman is going to point to the minimum guaranteed return, the so-called death benefit. The death benefit guarantees that your account will maintain a certain minimum value - usually the amount that has been invested. Sometimes the minimum guarantee will be some positive rate of return, but you can rest assure it will be a very low hurdle indeed, one that the profit-seeking insurance company expects to clear with ease. As well, the death benefit usually expires at around age 75, making it no real death benefit at all. In fact, given that stocks have returned approximately 11% annually from 1926 through 2007, it isn't surprising that the death benefit is triggered very rarely, perhaps for less than 2% of all annuities sold - almost sounds like a lottery ticket set up doesn't it?
Bottom line here folks is you gain zilch by putting your IRA and 401(k) money into a variable annuity, but you give up plenty in the form of commissions, extra fees and investing flexibility.
Okay, okay you say, no more putting already tax-deferred money into an expensive, inflexible variable annuity. But surely these things are worthwhile for non-qualified chunks of money right? In most cases no. Why?
Because gains are taxed as ordinary income, which can run as high as 35% versus the current 15% on long-term capital gains. Remember, gains are tax-deferred not tax free, meaning you will eventually pay taxes on the high-commission, high-expense investment vehicle's earnings. And the different tax rate makes a huge difference in your after-tax returns. It may take 15 to 20 years for the benefits of the tax-deferred variable annuity to make up for the more onerous tax treatment. Of course, it will take even longer to come out break even when you factor in the higher expenses.
Still want an annuity for your non-qualified money? Fine, at least cut out the snake-oil salesman and go direct to a low-fee, variable annuity provider. You can buy a low-cost variable annuity from many mutual fund and insurance companies such as Jefferson National, Vanguard or T. Rowe Price. Already own a high cost variable annuity? No problem. Make a tax-free transfer (1035 exchange) to a low-fee annuity (but don't forget to check on your surrender charge first).
