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The “Ups and Downs” of Variable Investments
[By Staff Writers]
The chief advantage of variable annuities is that investment income or gains are not currently taxable. However, when distributions are made, all gain is ordinary income, even if substantially all of the gains realized on the investment were capital gains.
Investments made directly by a Family Owned Business [FOB] member, for example, does not achieve tax deferral. But, assuming the dividends and other income are small (e.g., a growth portfolio), and all gains are capital gains taxed at the maximum rate, then direct investment may be a far superior method of investment.
Forbes summed it up, saying, “Don’t be a sucker!”
Despite Forbes’ warning, variable annuities are not necessarily an easy investment decision.
Sales Growth
Sales of variable annuities have continued to grow despite the reduction of capital gain rates in the recent years of the Bush Presidency, and the future is unknown. But, if the deferral is long enough, or if the portfolio throws-off ordinary income (e.g., a bond portfolio), then variable annuities may be desirable. However, doctors and medical professionals should exercise caution about variable annuities.
Fees and Expenses
Variable annuity fees vary widely from carrier to carrier but in many cases they are still high, putting such investments at a competitive disadvantage. If the fees are reasonable, and the medical professional client intends to invest in high yield bonds (also know as junk bonds), then a variable annuity can be attractive.
The same is true for traders who move in and out of funds and earn a large amount of short-term capital gains. In any event, all doctors should check the fees charged by the insurance company because they vary widely. Some funds that charge fees also have outperformed other funds.
Taxation
Investing in traditional equity can give rise to dividends of 1.5% (the average) that is subject to taxation. Variable annuities shelter the dividends, but at a cost often reaching 1.25%. This is not exactly an attractive investment trade-off.
Capital Gains
In addition, all capital gains derived from the portfolio are taxable as ordinary income when distributed; also not a good result.
Distributions upon Death
Assets held outright get a step-up in basis upon death. Variable annuity distributions are income-in-respect-of-a-decedent. Thus, there is no step-up in basis. This is harsh taxation, and the combined estate and income taxes can be 100% (e.g. the decedent’s estate may be is subject to a 5% surtax).
Thus, a 55-60% estate tax and a 35-40% ordinary income tax rate results in 100% taxation and confiscation. Counting the limitation on a deduction, the effective tax rate might be 42%, causing the combined taxes to exceed 100%. If the estate taxes can be deducted from the income taxes, the taxation of variable annuities is lessened.
Moreover, if a family business client has a charitable interest, using income-in-respect-of-a-decedent property to fund a gift to charity is a sound planning idea (the charity pays no income taxes and gifts to charities are not subject to estate taxes). Here, variable annuities may have one big advantage; they can prevent creditors from reaching assets. However, if this is a concern then the same results can be achieved by using an asset protection trust.
Assessment
Tax deferral always appeals to medical and other clients, but in some cases, variable annuity tax deferral may not be a effective tax planning tool. In addition, postmortem planning can help to reduce the tax burden to children.
Variable annuities require clear analysis and discussion. Doctors, and their accountants and financial advisors should discuss this issue before investing in them. The reason, quite simply, is that most doctors do not like to pay current tax and they may leap at a variable annuity which can result in increased taxation. How ironic!
Conclusion
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Filed under: Alternative Investments, Estate Planning, Financial Planning, Insurance Matters, Investing, Surveys and Voting, Taxation | Tagged: variable annuities | 6 Comments »
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