Variable annuities, already soaring in popularity thanks to the aging of the Baby Boom generation, may get another shot in the arm from President Clinton’s yet-to-be-enacted economic plan.
Life insurers say the variable annuity business has “virtually exploded,” with sales jumping a whopping 56 percent in 1992 alone. And now that Clinton is proposing to significantly hike tax rates, variable annuities are looking even more attractive to investors eager to defer taxes on their investment earnings.
“Higher taxes always make a product like this more popular,” says Alice Telian, annuity consultant at New England Mutual Life Insurance Co. in Boston. “Once we know for sure what Clinton is going to do, we would expect to see more of an effect.”
However, variable annuities are not a product to jump into lightly. While they can offer the dual advantage of allowing investors to earn comparatively high returns and pay no taxes until the money is withdrawn, they also exact heavy penalties against those who opt out before their time. Additionally, by and large, the fees you pay on variable annuities are high.
That’s because variable annuities are hybrid retirement products that wrap an insurance policy around mutual funds. You pay fees for the insurance and the management of the mutual funds. You must weigh the tax benefits you’re getting against the cost to determine if a variable annuity makes sense. Some people will find they’re better off just investing in mutual funds, regardless of the tax advantages.
Simplifying the complex
How do you make that determination? It’s not easy. Like many insurance products, variable annuities can be complex. And you need to understand them to decide whether they’re right for you.
In some ways, variable annuities resemble the 401(k) plans that some people have at work. For example, each variable annuity company offers several investment choices-perhaps a stock fund, a bond fund, a money market fund and a guaranteed interest fund. When you buy an annuity, you get to choose how much of your investment you want to put in each option, and that will determine how much money you have in the end.
Also like 401(k)s, your investment earnings accrue tax free until you pull the money out at retirement. But if you take the money out early, you may be faced with taxes and penalties that could amount to half of your investment earnings or more.
However, in other ways, a variable annuity differs substantially from a 401(k).
First, you make contributions to an annuity with after-tax dollars. Those who contribute to 401(k) plans do so with pretax dollars-a significant advantage.
Second, you get a slight insurance component when investing in variable annuities. Generally, what this insurance does is protect your heirs from your poor investment decisions.
A bonus for heirs
Specifically, the standard variable annuity promises to pay your heirs the amount you invested or the amount you have in your account, whichever is greater, if you happen to die before pulling your funds. So, if you have a heart attack while worrying about a 20 percent drop in the value of your annuity, your heirs won’t suffer.
And, where you get hit only with tax penalties when you withdraw 401(k) funds early, you usually must pay tax and insurance company penalties when you cash out of a variable annuity.
That’s because most annuity companies levy “surrender fees” against anyone who takes his or her money out in the first 5 to 10 years. Surrender fees vary, but they can start at 10 percent of your account value in the first year or two and ratchet down to 1 percent by year 10.
Tax penalties kick in if you cash out of your annuity before age 59 1/2. These penalties amount to income tax-at your regular income tax rates-on your annuity earnings, plus a 10 percent excise tax. If you don’t need the money but want to switch annuity companies, you can do that without tax penalties through a so-called 1035 exchange.
Additionally, annuity companies levy annual management and insurance fees on these accounts, which can add up to a significant percentage-if not all-of your investment earnings. And since you get only the tax breaks on your investment earnings, this can wipe out any benefit of investing in the annuity.
Overall, many experts say you should consider a variable annuity only if you are in the highest federal tax bracket, you are capable of leaving your funds largely untouched until retirement, and you’re comfortable making investment decisions and taking some investment risks.
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TUESDAY: How to choose a specific annuity.
