The first article, "Variables Claim Victory,"
is from Financial Planning magazine, the official magazine of the
International Association for Financial Planning. We thought that it would
provide you with some good information on variable annuities and how you might
compare and contrast mutual funds and variable annuities as investment options.
The second article, "An Obstacle Course for Creditors," shows how, depending on where an investor lives, variable annuities can provide some protection from legal judgments. It was taken from the March 2000 issue of Bloomberg Wealth Manager.
The third article, "Variable Annuities: What You Should Know," is taken from the Securities and Exchange Commission (SEC) web site. It provides a general description of variable annuities--what they are, how they work, and the charges you will pay.
The information provided here is the opinion of the authors and not SIMCO. Further, there is no relationship between the authors and SIMCO. Please request and examine prospectuses on either mutual funds or variable annuities before you invest.
Clients with excess funds available for retirement are often better off purchasing variable annuities than mutual funds.
Many clients, after fully funding their 401(k)s, IRAs and similar retirement vehicles, have additional funds available to set aside for retirement. Mutual funds and variable annuities are two popular investment vehicles frequently chosen for investment of excess funds earmarked for retirement. Whether clients choose funds or annuities to hold these additional funds is often determined by comparing the income tax treatment of these two investment choices.
By understanding that our current income tax laws favor variable annuities over mutual funds, financial advisers and insurance professionals can help their clients reach their retirement goals and reduce their income tax burdens.
Many investors have been led to believe that long-term ownership of mutual funds results in a maximum capital gains tax of 20%, while withdrawals from variable annuities are subject to significantly higher ordinary income tax rates. Mutual fund proponents argue that the difference between a capital gains rate of 20% and an ordinary income tax rate of 28% or more makes mutual funds more attractive than variable annuities as long-term investments. The assumption that holding appreciating mutual funds for more than a year will result in a maximum 20% capital gains tax is not accurate. Legally, mutual fund companies must, on an annual basis, distribute nearly all gains made by their funds to the funds' owners. These distributions are usually made late in the year and are reported to the IRS and fund owners on IRS Form 1099-DIV. Individual mutual fund owners use these forms to report mutual fund gains on their individual income tax returns.
Whether gains from holding a mutual fund receive 20% long-term capital gains tax treatment is almost exclusively a function of how long the mutual fund company holds the underlying investments it purchases and has almost nothing to do with how long a mutual fund owner holds his or her fund. An example is a mutual fund owned for three years. If the fund's managers do not hold any of the fund's investments for more than a year, its appreciation will be taxed to the owner as ordinary income and not at the more favorable 20% long-term capital gains rate.
Turnover ratio is the frequency with which a mutual fund buys and sells investments. A turnover ratio of 100 means that, on average, a mutual fund company sells and replaces its entire portfolio once a year. A turnover ratio of less than 100 means that a fund company, on average, takes more than a year to completely turn over its portfolio. A company with a turnover ratio of more than 100 means the company, on average, takes less than a year to turn over its portfolio. In short, it is a mutual fund company's turnover ratio, and not the length of time an investor holds his or her mutual fund, that dictates the investor's income tax rate on the funds' annual increase in value. A more accurate comparison of the income tax impact of owning mutual funds vs. variable annuities can be made once this is understood.
Another misunderstanding fund owners have is assuming a turnover ratio of less than 100 means that all investments held by a mutual fund company are held for at least a year before being sold, thereby resulting in a favorable 20% long-term capital gains treatment. This is not true. A turnover ratio of 100 signifies nothing more than, on average, a fund company sells and replaces its whole portfolio once a year. This means that some investments that are sold by the mutual fund may have been held for less than a year while others may have been held longer. Simply, a low turnover ratio does not provide mutual fund owners with protection from income tax obligations on a large part of their funds' gains. Equity funds currently have a turnover ratio of 82, for instance. This indicates that 82% of the stocks held in the average equity fund are sold and replaced within a year. This, in turn, means 82% of the gains made by such funds are short-term capital gains and taxed as ordinary income to these mutual funds' owners.
Assume two investors, Andy and Betty, are both in the same income tax bracket and 25 years old. Assume further that Andy buys $3,000 worth of a mutual fund with a turnover ratio of 100 each year. Each year Betty buys $3,000 worth of the same mutual fund through a variable annuity. Both investments increase at the annual rate of 15%. Who has the tax advantage? The answer is Betty, the variable annuity owner. The reason? Andy will pay ordinary income taxes each year on his mutual fund gains because of the fund's high turnover ratio. Betty will be able to defer all income taxes until she withdraws money from her variable annuity, an event that may not occur for years. The dramatic negative impact of Andy's income tax burden can be seen when the total value of these two hypothetical accounts is calculated over a typical holding period. For example, by applying a 30% combined state and federal income tax burden, Andy's mutual fund holdings will be worth $600,000 in 30 years, while Betty's variable annuity will grow to approximately $1.5 million during the same period.
When mutual fund proponents are faced with such results, they usually claim that increased costs associated with variable annuities reduce their tax advantage. Assuming, in the above example, that the additional cost of owning a variable annuity would reduce Betty's rate of return to 14%, Betty's variable annuity would still contain $1.22 million after 30 years, while Andy's mutual fund account would contain only $600,000.
Mutual fund proponents claim the negative tax impact of owning mutual funds with high turnover ratios can be eliminated by purchasing funds with low turnover ratios, thus allowing fund owners to obtain the more favorable 20% long-term capital gains rate.
This solution is unrealistic for several reasons. For example:
Financial advisers and insurance professionals must emphasize to clients that long-term mutual fund ownership does not guarantee the 20% capital gains rate often cited by fund proponents. Once clients realize that they may be subject to ordinary income taxation on a large portion of their mutual fund gains, the advantage of buying variable annuities to defer this tax should become apparent.
While it is important for fund owners to realize they will most likely pay ordinary income taxes on a substantial portion of their funds' gains, it is just as important for variable annuity owners to understand that being in a 28% income tax bracket does not mean they will pay income taxes on annuity withdrawals at this rate. The 28% income tax rate so frequently quoted by mutual fund advocates is a marginal tax bracket. Much of the taxable income of all taxpayers in that tax bracket is taxed at rates as low as 15%. What this means, for example, is that married taxpayers with gross incomes well in excess of $100,000 will pay a 20% maximum in income taxes even though they are in a 28% bracket. This is true even if much of this income comes from annuity withdrawals.
Example: For 1999, John and Mary Smith, both 60 and retired, have a combined gross income of $114,000. Their only deductions are the standard deduction of $7,200 and a combined personal exemption of $5,500, reducing their gross income to a taxable income of $101,300. They are in the 28% marginal tax bracket. Of their retirement income, $55,000 is a fully taxable withdrawal from a variable annuity purchased by John years ago. The Smiths' tax burden would be calculated as follows:
As can be seen from the above example, a tax of $22,767.50 on a gross income of $114,000 results in a maximum income tax of 20%. This example is significant because it demonstrates that married investors in a 28% marginal tax bracket who do not expect to have gross incomes exceeding $114,000 during retirement will pay a maximum income tax of 20% regardless of how much of this income is derived from variable annuity withdrawals. It is important to point out to clients that the amount of gross income taxpayers can have and not be subject to an income tax exceeding 20% has consistently been increased by Congress over the years and should continue into the future. Once clients understand that their retirement income is unlikely to be subject to an income tax of more than 20% (even though they are in the 28% marginal tax bracket), it will help them realize that it does not make good economic sense to pay 20% or more annually in income taxes on a mutual fund portfolio.
Another advantage of variable annuities is that the owner can switch the mutual funds he owns for other funds within the annuity without triggering any tax consequences. In addition, by complying with section 1035 of the Internal Revenue Code, one variable annuity can be exchanged for a completely different variable annuity without generating a tax. The inability of a mutual fund owner to obtain similar income tax benefits can be costly.
Example: Ten years ago, Jim purchased an index fund for $10,000 and recently decided to switch from his index fund to a growth fund within the same mutual fund family. At the time of this transaction, the index fund had grown in value to $40,000. Fourteen months later, Jim sold his growth fund for $46,000 and switched to an international fund in a different fund family. These two transactions will result in an income tax burden to Jim of $7,200, or nearly 16% of his portfolio's value. This figure can be higher if there are any commissions incurred as a result of these transactions. Had Jim made the same two transactions while owning his mutual funds within a variable annuity, his tax burden would have been zero.
Mutual fund proponents compare their funds with variable annuities as if the owners of these funds and annuities never make changes to their holdings. Advisers must impress upon their clients that, in reality, this is rarely the case. Both mutual fund and variable annuity owners buy, sell, switch and transfer investments with some regularity. When the income tax burden and other costs of these transactions are explained to clients, the case for owning variable annuities rather than mutual funds becomes more compelling.
Paying income taxes annually on mutual fund holdings does not guarantee a tax-advantaged retirement. Mutual fund proponents imply that there is some future tax reward in store for fund owners who endure paying income taxes on their funds year in and year out. This rarely proves to be the case. Assume for example that Tom and Sally are 60-year-old twins who both made annual investments of $1,500 for the last 25 years. Tom invested his money in mutual funds returning 12% and paid 20% capital gains taxes each year on the growth of his fund holdings. Sally invested in a variable annuity and deferred all income taxes. Because of additional costs, Sally's return on her annuity was only 11%. Today, Tom's account would contain $152,300 while Sally's account would contain $190,500.
Assume both twins must now draw income from their accounts for retirement. If Tom transfers his mutual fund to a more conservative investment such as corporate bonds, the income he will receive from his $152,300 retirement account will be subject to ordinary income taxes. If the corporate bonds yield 10% and Tom pays 20% in income taxes on this amount, his net annual income will be $12,184 from his bonds. Sally will also have to pay ordinary income taxes on her annuity withdrawals, but she will have a larger retirement income because her annuity value is $190,500. If Sally withdraws 10% of her annuity each year and pays 20% in income taxes on this withdrawal, Sally will have an annual retirement income of $15,240.
Tom will not be much better off if he decides to keep his mutual fund portfolio intact during his retirement. An annual $15,230 distribution from his mutual fund (i.e., 10% of his portfolio) will yield an after-tax retirement income of $12,184, assuming a 20% income tax rate. His sister Sally can withdraw $19,050 annually from her annuity (i.e., 10% of the annuity's value), pay income tax of 20% and receive a net retirement income in excess of $15,000.
Once clients realize that annually paying income taxes on a mutual fund portfolio does not provide them with any real tax advantage in retirement, they may well wonder why they paid this tax instead of deferring it with a variable annuity and increasing their retirement nest egg.
Mutual fund ownership, unlike variable annuity ownership, may subject Social Security income to taxation. Single taxpayers with adjusted gross incomes of $25,000 or more, and married couples with adjusted gross incomes in excess $44,000, are subject to having from 50% to as much as 85% of their Social Security income subject to ordinary income taxes. This additional tax burden can be a major problem for retired persons who have large mutual fund portfolios.
Example: Jack is 65 years old and has pension income of $20,000 a year. He has a mutual fund portfolio worth $150,000 and receives $10,000 a year in Social Security. Although Jack does not need any money from his mutual funds, the fund annually distributes $15,000 in capital gains to Jack. This distribution increases Jack's annual income to $45,000. Because of this, Jack's Social Security check will be partially subject to income taxes.
Had Jack held his mutual funds within a variable annuity, none of his Social Security retirement income would have been subject to income taxes. Gains made within variable annuities are tax deferred and do not count in determining whether Social Security retirement income will be taxed. Retired persons who find themselves in Jack's situation frequently ask whether shifting their mutual funds to a tax-free bond fund would solve their problem. The answer is no. The reason for this is that, unlike tax-deferred income, tax-free income must be taken into consideration when determining whether Social Security retirement income will be subject to income taxes.
Converting his mutual fund portfolio to a variable annuity is one of the best ways for Jack to protect his Social Security retirement income from taxation. If he chooses this option, he may well question having paid annual income taxes on mutual funds only to realize that, in order to protect his Social Security income during retirement, he should have initially invested in a variable annuity.
Mutual fund proponents treat the existence of long-term capital gains rates of 20%-and the recently reduced holding period of 12 months to obtain these rates-as if permanently etched in stone by Congress. Nothing could be further from the truth. History has shown that capital gains rates and holding periods to obtain favorable capital gains treatment have fluctuated with some regularity over time. A future increase in long-term capital gains rates to anything over 20% would make the tax advantage of purchasing variable annuities instead of mutual funds much more pronounced than it is today. Mutual fund owners who have paid 20% capital gains rates on their funds for many years only to learn just before retirement that these rates will be increased will surely question why they didn't purchase a variable annuity instead of mutual funds. Even if Congress does not to raise the current 20% long-term capital gains tax, it is quite possible that it could, sometime in the future, adjust the holding period necessary to obtain this favorable tax rate. An adjustment from a 12-month holding period to an 18-month one would force many mutual funds to make distributions to fund owners that would not qualify for long-term capital gains, resulting in mutual fund investors having to pay much higher ordinary income tax rates on their fund holdings.
Also, Congress may replace our current income tax structure or adopt a flat tax. Tax reform is one of the major election issues concerning both politicians and voters alike. Recently, the House of Representatives voted to terminate the current income tax system and replace it by July 4, 2002. It is quite possible that the current system could be replaced by a sales or consumption tax. Variable annuity owners will reap a huge windfall if this occurs. Variable annuity owners who have deferred income taxes for many years may completely avoid income taxes in retirement if the current tax structure is indeed replaced by a sales or consumption tax. On the other hand, mutual fund owners who are currently paying income taxes each year on their portfolios will be the big losers if a consumption or sales tax replaces our current income tax structure.
Congress has already embraced the idea of tax-free retirement income. Except for persons with large retirement incomes, Social Security is a form of tax-free retirement income. The newly created Roth IRA allows people to save for retirement and ultimately receive tax-free retirement income. Moving to a nonincome-based tax structure and allowing retired persons to make income tax-free withdrawals from 401(k)s, 403(b)s and variable annuities may be the next step in this process.
Even if Congress does not replace our current income tax structure, it seems almost certain that the income tax code of the United States will have to be simplified. Voters are demanding simplification, and Congress is promising it. Most proposals to simplify the current tax code involve the imposition of some form of flat tax. Flat-tax rates ranging from 10% to 17% have been proposed. If a flat tax of 17% is adopted, fund owners and variable annuity owners will be subject to the same income tax burden at retirement. A mutual fund owner may well question whether it was worth paying 20% or more in income taxes on fund holdings over the years only to find himself in a 17% tax bracket at retirement-especially if his neighbor who deferred all income taxes with variable annuities winds up in the same bracket.
At death, beneficiaries receive more from variable annuities than from mutual funds. Mutual fund advocates argue that because these funds, unlike variable annuities, receive a stepped-up cost basis at the owner's death, beneficiaries receiving mutual funds from a decedent's estate are better off than beneficiaries who receive variable annuities. This is not true. The concept of stepped-up cost basis allows beneficiaries inheriting mutual funds to treat such funds as if they purchased them on the decedent's date of death for their fair market value on that date. When beneficiaries later sell these mutual funds, they will only pay capital gains taxes on the difference between the sale price and the funds' market value on the date the decedent died. This is true even though the decedent may have paid much less for the funds.
An illustration: Assume George paid $100,000 for a mutual fund portfolio and, at his death, these funds are worth $200,000. If George leaves these funds to his daughter Jill and she sells the funds a short while later for $200,000, there will be no capital gains taxes because Jill's cost will be deemed to be $200,000, the value of the mutual funds on the date her father died.
Variable annuities do not get a stepped-up cost basis when the owner dies. Beneficiaries of these annuities must use the same cost basis that their decedent had in the annuity prior to death. The beneficiary of a variable annuity must pay ordinary income taxes when they liquidate any annuity received from a decedent. This tax is imposed on the difference between the decedent's cost basis and the value of the annuity when liquidated. Just because mutual funds, unlike variable annuities, receive a stepped-up basis when inherited does not automatically mean that beneficiaries are better off inheriting mutual funds rather than variable annuities.
Example: Fifteen years ago, Ellen invested $50,000 in a mutual fund that grew at 14% annually. Each year, 20% capital gains taxes reduced this growth rate to 11.2%. Ellen recently died and left her mutual fund, now worth $245,778, to her four children, who sold the fund soon after for $245,778. The children avoided capital gains taxes because the cost basis of the mutual fund in their hands was deemed to be $245,778. In short, the children received the full $245,778 value of the inherited mutual fund.
Another example: Fifteen years ago, Frank purchased a variable annuity for $50,000. The annuity grew at a rate of 14%, but due to the costs associated with the annuity, the rate of return was reduced to 13%. Frank recently died, leaving his annuity-now worth $312,714-to his four children, who immediately liquidated it. The children were required to pay $52,543 in ordinary income taxes on the annuity growth, reducing their net inheritance to $260,171.
From the examples above, it can be seen that the beneficiaries of variable annuities are frequently better off economically than those beneficiaries receiving mutual funds from a decedent-even after factoring in the supposed income tax advantage of the stepped-up cost basis afforded to mutual funds.
At retirement, a variable annuity owner may elect to receive a lifetime income stream (annuitization). When annuitization occurs, payments made by the annuity company are treated as being part taxable growth and part tax-free return of the annuitant's investment. As each payment is made, only those portions representing growth are subject to ordinary income taxation. The portion representing a return of the annuitant's investment is not subject to income taxation at all. This special tax treatment makes receiving income from an annuity less of a tax burden than receiving income from a mutual fund portfolio. The following example demonstrates this tax advantage of variable annuities.
Example: Mike is 71 and retired. Over the past several years, Mike has invested $60,000 in a variable annuity currently worth $120,000. Mike decides to annuitize his annuity, so it will pay him $12,000 a year. By electing annuitization, only $7,500 of Mike's $12,000 annuity payment will be considered taxable income. The remaining $4,500 is a tax-free return of Mike's investment. If Mike elects a life annuity guaranteed for 10 years, his $12,000 annual payments will continue as long as he lives with a guarantee that Mike or his heirs will receive a minimum of $120,000 in total payments.
If Mike had invested $60,000 in a mutual fund that had grown in value to $120,000, he could possibly duplicate the tax advantages of annuitization by keeping detailed investment records, carefully selecting which funds to sell, timing sales precisely and complying with IRS guidelines that deal with mutual fund sales. However, absent the annuitization provided by a variable annuity, Mike could not be assured that he would receive an annual income of $12,000 payable for a minimum of 10 years with a guarantee that these payments would continue for his entire lifetime.
Time quickly erodes any perceived income tax advantage favoring mutual funds. Depending on rates of return, investment costs, holding periods and tax rates, it is only a matter of time before the tax-deferral advantage of variable annuity ownership will overcome any perceived income tax advantage of owning mutual funds.
Example: Bill, who is 60, has invested $5,000 a year in mutual funds that have earned 14% a year for the past 12 years. Each year he paid a 20% capital gains tax on the growth of his mutual funds. At the same time, Bill's twin sister Brenda invested $5,000 a year in a variable annuity. The annuity earned 13% tax-deferred return each year. (Brenda's return is less than Bill's, to factor in the alleged higher costs of variable annuity ownership.) Bill's mutual fund portfolio is currently worth $128,000 while Brenda's annuity is worth $145,000. If Bill takes a 10% distribution from his fund (i.e., $12,800) and pays a 20% capital gains tax on it, he will net $10,240. If Brenda takes a 10% withdrawal from her variable annuity (i.e., $14,500) and pays as much as 28% ordinary income tax on it, she will net $10,440. (Using a more realistic income tax rate of 20%, Brenda's net income would increase to $11,600.) Because of the tax deferral, Brenda's annuity currently could produce a retirement income that would be larger than Bill's. For every year beyond 12, Brenda's potential retirement income will continue to grow steadily larger than Bill's. For example, if Bill and Brenda fund their retirement accounts for 25 years, Brenda's retirement income will be from 20% to 34% more than Bill's.
When advisers help clients compare mutual funds with variable annuities by
using reasonable assumptions, it should quickly become apparent that variable
annuities will, at some point in time, overcome all of the perceived income tax
advantages attributed to mutual fund ownership.
--John P. Huggard is an attorney and estate planning specialist with Huggard,
Obiol and Blake in Raleigh, N.C.
Depending on where your client lives, variable annuities can provide some protection from legal judgments.
Variable annuities have become the darlings of doctors, business owners, and others who are litigation targets. One reason is that while stocks and mutual funds held in ordinary accounts are vulnerable to attack by creditors, annuity contracts afford some degree of protection. The extent of the protection, however, varies widely depending on the law in the state where the annuity buyer lives. "There's no guarantee that money you put into variable annuities will be fully protected," says Gideon Rothschild, a partner in the New York law firm Moses & Singer and chairman of the asset-protection planning committee of the American Bar Association. "But variable annuities create obstacles, certainly, in creditors' paths to collecting judgments.
The more obstacles you create, the better able you'll be to negotiate a settlement." Of course, this protection comes at a price. In most cases, investing via variable annuities is about 30 percent more expensive than using mutual funds or investing directly in stocks. What's more, because all income from annuities is taxed as ordinary income, investors never get the chance to claim any income as tax-favored capital gains in the way they might if they invested directly in the market or in mutual funds.
As a rule, state legislatures are willing to offer protection to annuity investors because they want debtors to maintain some minimum level of financial well-being to avoid becoming a burden on the state. Many states, for instance, exempt life insurance from creditors' claims because life insurance is intended to support the debtor's family after his or her death. This reasoning also extends to commercial annuity products, which often fill the same role.
However, because annuities are often marketed as tax-favored investment vehicles, not retirement savings plans, the protections for them are less extensive than those for life insurance--and not always as clear. "The creditor-protection movement is relatively new," says Alexander Bove Jr., a Boston attorney. "So there are still many questions that cannot be answered."
Each state, for example, has its own view, criteria, and history about how creditor protection should be achieved, says Vernon Jacobs, an accountant in Prairie Village, Kan., and publisher of The Jacobs Report on Asset Protection Strategies, a consumer newsletter. "There's no uniformity in this area," he says.
Although federal law confers only minimum protection for investments in variable annuities, the laws in six states--Colorado, Florida, Michigan, New Mexico, Oklahoma, and Texas--fully protect such investments. Five other states--Massachusetts, Montana, New Hampshire, Virginia, and West Virginia--offer no protection at all. Twenty states protect part of the investment or offer limited protection if certain requirements are met--for example, if the policy proceeds are payable to a spouse or dependent children, or the annuity is held in a qualified retirement plan. In some other states the degree to which annuities are immune from creditors depends on the courts' interpretations, and these go in all directions.
The rest, however, have no precedent for dealing with creditor protection for variable annuities, and that can be dangerous. "You may be the first if you use it for that purpose," says Michael Lane, president of Advisor Resources in Louisville, Ky., a company that offers products and services to fee-based financial advisers. "That's not a good place to be. We recommend researching other forms of asset protection where there's no precedent or negative case law." (A complete listing of protections for variable annuities by state can be found in an article from Moses & Singer LLP.)
Still, the potential protection that variable annuities offer to someone who may become bankrupt warrants a careful and considered review by both asset-protection planners and bankruptcy counsel acting in a pre-bankruptcy planning function, says Rothschild. But, he points out, people considering buying variable annuities for creditor protection should review the laws in their state well in advance. "Too many people come to me when it's too late," he notes. "It's difficult to do any effective asset-protection planning once you've already been sued. The time to do anything like that is in advance."
The reason is simple: any protection from creditors granted under federal or state law would be voided if the purchase is considered a fraudulent transfer. The transfer would then be unwound, and the assets would become unprotected.
Determining what kind of transaction constitutes a fraudulent transfer, however, is far from simple. In essence, fraudulent transfers are considered transfers "for less-than-adequate consideration" that result in your becoming insolvent. For example, "if you make yourself insolvent by means of making a gift, the courts can give the property back to your creditors," Jacobs says. But not always. "Even if you make a gift and you're insolvent after you make it, if the statute of limitations has run out, the creditor is out of luck." In most states, the statute of limitations for fraudulent transfers is between five and seven years.
Most states require an actual transfer of ownership for the transaction to be considered fraudulent. This requirement protects annuity owners, who argue that using money to buy annuities does not necessitate a change in ownership. But state legislatures are beginning to take matters into their own hands to crack down on perceived abuses. Florida, for example, which is otherwise generous in protecting assets, recently passed a law that puts conversions of nonexempt assets to exempt ones on par with other fraudulent transfers.
In addition, two other states, Louisiana and New York, now impose rules about the timing of variable-annuity purchases to prevent fraudulent transfers. Louisiana, which generally offers unlimited protection to annuity owners, will protect no more than $35,000 if the annuity owner files for bankruptcy within nine months of the issuance of the policy. New York will protect only $5,000 if annuities are purchased within six months of a judgment being rendered.
In many states, however, timing is less relevant. "Case law indicates that annuities still might be protected under state law even if you buy them when there are problems on the horizon," Rothschild says. Nonetheless, advance planning is still the safer course. "Obviously, the more time that lapses between your purchase of the variable annuity and the event that occurs that creates liability for you, the better you can defend it," he says.
The size of the purchase can also play a role in the amount of protection annuities afford. Generally, the more money you invest in an annuity, the less protection you can count on. That's because the legislation granting exemptions was originally designed to prevent destitution of debtors' families. Federal law--as well as the law in Arkansas, Mississippi, New York, and several other states--limits the protection to the "reasonable financial needs" of a debtor and his or her dependents.
Obviously, such a standard is subject to widely varying interpretations. "You have to look at case law to see what the courts consider reasonable, necessary support, and the decisions go every which way," Rothschild says. But, he points out, "the more money you invest in the annuity, the more it smells like you did it for fraudulent purposes."
So far, the largest case dealing with creditor protection for variable annuities was a 1987 U.S. Bankruptcy Court case involving a doctor named James Johnson in Minnesota. Johnson, who had purchased $232,000 worth of variable annuities, filed for bankruptcy after his other investments went bad. The court said the annuities were protected from creditors. The result, however, might very well be different if an individual liquidated a $5 million investment account and bought a variable annuity for its creditor protection, Rothschild says.
Some states limit protection by capping the monthly amounts individuals can receive under annuities and making the balance available to creditors. The cap in Alabama, South Dakota, and Washington, for example, is $250 per month; Delaware, Idaho, Kentucky, Maine, Nevada, Vermont, and Wyoming protect up to $350 a month; New Jersey and Oregon protect $500 monthly. Other states set a maximum amount payable under an annuity that will be protected--$100,000 per policy, and $200,000 in aggregate, in North Dakota; $10,000 in Nebraska.
Another factor that can affect the extent of the protection afforded is the beneficiary designation. More than a dozen states, among them Indiana, Maryland, and Ohio, provide protection when the owners of the annuities are not also the beneficiaries of the policy.
Ownership matters, too. When you have the right to name the beneficiary, cash in the policy, or borrow against its cash value, you are considered the owner of the policy. Unless you are protected by state law, you can be forced to liquidate the contract and make the proceeds available to creditors. The most effective way to protect money in a variable annuity is to make someone else the owner of the contract, Jacobs points out. When you make a gift of an existing contract, however, you may owe gift tax, he cautions.
Policy owners should also be careful to avoid naming their estates beneficiaries of their variable annuities, because the money will then become available to creditors after the owner's death. Also, you forfeit the tax deferral for money accumulated in an annuity if the policy is owned by a corporation or a partnership. Money accumulated in variable annuities held in a grantor trust, however, will be tax deferred. What's more, if the trust owns the policy and state law exemptions apply to the annuitant or beneficiary, the trust format should not affect the creditor protection, Rothschild says. Yet in general, most people don't fund trusts with variable annuities because problems arise, he adds. Assets in trusts set up for the settlor's own benefit, for instance, are generally available to creditors.
Four states--Alaska, Delaware, Nevada, and Rhode Island--now let people establish trusts for their own benefit while protecting trust assets from creditors. But these so-called self-settled trusts are still untested. "When people living outside these states set up trusts under Alaska, Delaware, Nevada, or Rhode Island law, there's a question about whether the courts will apply those laws in lieu of their own local laws," Rothschild says.
One other hitch: Some state laws protect annuities in the accumulation stage but don't protect proceeds payable by the policy. In California, for example, only unmatured policies are wholly exempt from creditors.
In short, although variable annuities provide creditors with plenty of obstacles, they also provide some legal snarls for the annuity owners themselves.
-- Carole Gould, an attorney who writes on business, taxes, and investing, is a frequent contributor to the Sunday business section of The New York Times.
Variable annuities have become a part of the retirement and investment plans of
many Americans. Before you buy a variable annuity, you should know some of the
basics – and be prepared to ask your insurance agent, broker, financial
planner, or other financial professional lots of questions about whether a
variable annuity is right for you.
This is a general description of variable annuities – what they are, how they work, and the charges you will pay. Before buying any variable annuity, however, you should find out about the particular annuity you are considering. Request a prospectus from the insurance company or from your financial professional, and read it carefully. The prospectus contains important information about the annuity contract, including fees and charges, investment options, death benefits, and annuity payout options. You should compare the benefits and costs of the annuity to other variable annuities and to other types of investments, such as mutual funds.
What Is a Variable Annuity?
A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.
A variable annuity offers a range of investment options. The value of your investment as a variable annuity owner will vary depending on the performance of the investment options you choose. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.
Although variable annuities are typically invested in mutual funds, variable annuities differ from mutual funds in several important ways:
First, variable annuities let you receive periodic payments for the rest of your life (or the life of your spouse or any other person you designate). This feature offers protection against the possibility that, after you retire, you will outlive your assets.
Second, variable annuities have a death benefit. If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount – typically at least the amount of your purchase payments. Your beneficiary will get a benefit from this feature if, at the time of your death, your account value is less than the guaranteed amount.
Third, variable annuities are tax-deferred. That means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals
Caution!
Other investment vehicles, such as IRAs and employer-sponsored
401(k) plans, also may provide you with tax-deferred growth and other tax
advantages. For most investors, it will be advantageous to make the maximum
allowable contributions to IRAs and 401(k) plans before investing in a variable
annuity.
In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity. Under these circumstances, consider buying a variable annuity only if it makes sense because of the annuity's other features, such as lifetime income payments and death benefit protection. The tax rules that apply to variable annuities can be complicated – before investing, you may want to consult a tax adviser about the tax consequences to you of investing in a variable annuity.
Remember: Variable annuities are designed to be long-term investments, to meet retirement and other long-range goals. Variable annuities are not suitable for meeting short-term goals because substantial taxes and insurance company charges may apply if you withdraw your money early. Variable annuities also involve investment risks, just as mutual funds do.
How Variable Annuities Work
A variable annuity has two phases: an accumulation phase and a payout phase.
During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. For example, you could designate 40% of your purchase payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. The money you have allocated to each mutual fund investment option will increase or decrease over time, depending on the fund's performance. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account. A fixed account, unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum (e.g., 3% per year).
Example: You purchase a variable annuity with an initial purchase payment of $10,000. You allocate 50% of that purchase payment ($5,000) to a bond fund, and 50% ($5,000) to a stock fund. Over the following year, the stock fund has a 10% return, and the bond fund has a 5% return. At the end of the year, your account has a value of $10,750 ($5,500 in the stock fund and $5,250 in the bond fund), minus fees and charges (discussed below).
Your most important source of information about a variable annuity's investment options is the prospectus. Request the prospectuses for the mutual fund investment options. Read them carefully before you allocate your purchase payments among the investment options offered. You should consider a variety of factors with respect to each fund option, including the fund's investment objectives and policies, management fees and other expenses that the fund charges, the risks and volatility of the fund, and whether the fund contributes to the diversification of your overall investment portfolio. The SEC's online publication, Mutual Fund Investing: Look at More Than a Fund's Past Performance, provides information about these factors. Another SEC online publication, Invest Wisely: An Introduction to Mutual Funds, provides general information about the types of mutual funds and the expenses they charge.
During the accumulation phase, you can typically transfer your money from one investment option to another without paying tax on your investment income and gains, although you may be charged by the insurance company for transfers. However, if you withdraw money from your account during the early years of the accumulation phase, you may have to pay "surrender charges," which are discussed below. In addition, you may have to pay a 10% federal tax penalty if you withdraw money before the age of 59½.
At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals (generally monthly).
If you choose to receive a stream of payments, you may have a number of choices of how long the payments will last. Under most annuity contracts, you can choose to have your annuity payments last for a period that you set (such as 20 years) or for an indefinite period (such as your lifetime or the lifetime of you and your spouse or other beneficiary). During the payout phase, your annuity contract may permit you to choose between receiving payments that are fixed in amount or payments that vary based on the performance of mutual fund investment options.
The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments. Be aware that some annuities do not allow you to withdraw money from your account once you have started receiving regular annuity payments.
In addition, some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you will start receiving annuity payments right after you purchase the annuity.
The Death Benefit and Other Features
A common feature of variable annuities is the death benefit. If you die, a person you select as a beneficiary (such as your spouse or child) will receive the greater of: (i) all the money in your account, or (ii) some guaranteed minimum (such as all purchase payments minus prior withdrawals).
Example: You own a variable annuity that offers a death benefit equal to the greater of account value or total purchase payments minus withdrawals. You have made purchase payments totaling $50,000. In addition, you have withdrawn $5,000 from your account. Because of these withdrawals and investment losses, your account value is currently $40,000. If you die, your designated beneficiary will receive $45,000 (the $50,000 in purchase payments you put in minus $5,000 in withdrawals).
Some variable annuities allow you to choose a "stepped-up" death benefit. Under this feature, your guaranteed minimum death benefit may be based on a greater amount than purchase payments minus withdrawals. For example, the guaranteed minimum might be your account value as of a specified date, which may be greater than purchase payments minus withdrawals if the underlying investment options have performed well. The purpose of a stepped-up death benefit is to "lock in" your investment performance and prevent a later decline in the value of your account from eroding the amount that you expect to leave to your heirs. This feature carries a charge, however, which will reduce your account value.
Variable annuities sometimes offer other optional features, which also have extra charges. One common feature, the guaranteed minimum income benefit, guarantees a particular minimum level of annuity payments, even if you do not have enough money in your account (perhaps because of investment losses) to support that level of payments. Other features may include long-term care insurance, which pays for home health care or nursing home care if you become seriously ill.
You may want to consider the financial strength of the insurance company that sponsors any variable annuity you are considering buying. This can affect the company's ability to pay any benefits that are greater than the value of your account in mutual fund investment options, such as a death benefit, guaranteed minimum income benefit, long-term care benefit, or amounts you have allocated to a fixed account investment option.
Caution!
You will pay for each benefit provided by your variable annuity. Be
sure you understand the charges. Carefully consider whether you need the
benefit. If you do, consider whether you can buy the benefit more cheaply as
part of the variable annuity or separately (e.g., through a long-term
care insurance policy).
Variable Annuity Charges
You will pay several charges when you invest in a variable annuity. Be sure you understand all the charges before you invest. These charges will reduce the value of your account and the return on your investment. Often, they will include the following:
Other charges, such as initial sales loads, or fees for transferring part of your account from one investment option to another, may also apply. You should ask your financial professional to explain to you all charges that may apply. You can also find a description of the charges in the prospectus for any variable annuity that you are considering.
Tax-Free “1035” Exchanges
Section 1035 of the U.S. tax code allows you to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in your current variable annuity account. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that you prefer, such as a larger death benefit, different annuity payout options, or a wider selection of investment choices.
You may, however, be required to pay surrender charges on the old annuity if you are still in the surrender charge period. In addition, a new surrender charge period generally begins when you exchange into the new annuity. This means that, for a significant number of years (as many as 10 years), you typically will have to pay a surrender charge (which can be as high as 9% of your purchase payments) if you withdraw funds from the new annuity. Further, the new annuity may have higher annual fees and charges than the old annuity, which will reduce your returns.
Caution!
If you are thinking about a 1035 exchange, you should compare both
annuities carefully. Unless you plan to hold the new annuity for a significant
amount of time, you may be better off keeping the old annuity because the new
annuity typically will impose a new surrender charge period. Also, if you
decide to do a 1035 exchange, you should talk to your financial professional or
tax adviser to make sure the exchange will be tax-free. If you surrender the
old annuity for cash and then buy a new annuity, you will have to pay tax on
the surrender.
Bonus Credits
Some insurance companies are now offering variable annuity contracts with "bonus credit" features. These contracts promise to add a bonus to your contract value based on a specified percentage (typically ranging from 1% to 5%) of purchase payments.
Example: You purchase a variable annuity contract that offers a bonus credit of 3% on each purchase payment. You make a purchase payment of $20,000. The insurance company issuing the contract adds a bonus of $600 to your account.
Caution!
Variable annuities with bonus credits may carry a downside, however
– higher expenses that can outweigh the benefit of the bonus credit offered.
Frequently, insurers will charge you for bonus credits in one or more of the following ways:
Before purchasing a variable annuity with a bonus credit, ask yourself – and the financial professional who is trying to sell you the contract – whether the bonus is worth more to you than any increased charges you will pay for the bonus. This may depend on a variety of factors, including the amount of the bonus credit and the increased charges, how long you hold your annuity contract, and the return on the underlying investments. You also need to consider the other features of the annuity to determine whether it is a good investment for you.
Example: You make purchase payments of $10,000 in Annuity A and $10,000 in Annuity B. Annuity A offers a bonus credit of 4% on your purchase payment, and deducts annual charges totaling 1.75%. Annuity B has no bonus credit and deducts annual charges totaling 1.25%. Let's assume that both annuities have an annual rate of return, prior to expenses, of 10%. By the tenth year, your account value in Annuity A will have grown to $22,978. But your account value in Annuity B will have grown more, to $23,136, because Annuity B deducts lower annual charges, even though it does not offer a bonus.
You should also note that a bonus may only apply to your initial premium payment, or to premium payments you make within the first year of the annuity contract. Further, under some annuity contracts the insurer will take back all bonus payments made to you within the prior year or some other specified period if you make a withdrawal, if a death benefit is paid to your beneficiaries upon your death, or in other circumstances.
Caution!
If you already own a variable annuity and are thinking of exchanging
it for a different annuity with a bonus feature, you should be careful. Even if
the surrender period on your current annuity contract has expired, a new
surrender period generally will begin when you exchange that contract for a new
one. This means that, by exchanging your contract, you will forfeit your
ability to withdraw money from your account without incurring substantial
surrender charges. And as described above, the schedule of surrender charges
and other fees may be higher on the variable annuity with the bonus credit than
they were on the annuity that you exchanged.
Example:You currently hold a variable annuity with an account value of $20,000, which is no longer subject to surrender charges. You exchange that annuity for a new variable annuity, which pays a 4% bonus credit and has a surrender charge period of eight years, with surrender charges beginning at 9% of purchase payments in the first year. Your account value in this new variable annuity is now $20,800. During the first year you hold the new annuity, you decide to withdraw all of your account value because of an emergency situation. Assuming that your account value has not increased or decreased because of investment performance, you will receive $20,800 minus 9% of your $20,000 purchase payment, or $19,000. This is $1,000 less than you would have received if you had stayed in the original variable annuity, where you were no longer subject to surrender charges.
In short:Take a hard look at bonus credits. In some cases, the "bonus" may not be in your best interest.
Ask Questions Before You Invest
Financial professionals who sell variable annuities have a duty to advise you as to whether the product they are trying to sell is suitable to your particular investment needs. Don't be afraid to ask them questions. And write down their answers, so there won't be any confusion later as to what was said.
Variable annuity contracts typically have a "free look" period of ten or more days, during which you can terminate the contract without paying any surrender charges and get back your purchase payments (which may be adjusted to reflect charges and the performance of your investment). You can continue to ask questions in this period to make sure you understand your variable annuity before the "free look" period ends.
Before you decide to buy a variable annuity, consider the following questions:
Remember: Before purchasing a variable annuity, you owe it to yourself to learn as much as possible about how they work, the benefits they provide, and the charges you will pay.
Sosnowy Investment Management Company. (SIMCO)
3883 Telegraph Road, Suite 100
Bloomfield Hills, MI 48302
Phone: 800-526-2152
Fax: 248-642-6741
Contact: info@lastingwealth.com
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