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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 |
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Annuities,
Physicians and most investors may have made money recently with annuities. But, at what cost and what about the future?
If you need a “guarantee”, why not just invest less, save the commissions and all related fees, and keep the remainder in safer cash or bonds, etc.
Marvin
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FINRA
I just learned that FINRA has fined five bank broker-dealers a total of $1.65 million for deficient supervision and procedures involving variable annuity, mutual fund or unit investment trust transactions.
http://www.fa-mag.com/fa-news/4330-finra-fines-bank-b-ds-for-variable-annuity-sales.html
Ralph
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CMPs
Variable annuities seem to be loved by financial advisors everywhere — except in the RIA world of fiduciary advisors and physician focused Certified Medical Planners™ http://www.CertifiedMedicalPlanner.com
Perhaps the lack of love between CMPs™/ RIAs and VAs is a two-way street? Simply put, RIAs and CMPs™ don’t typically sell this financial product because most come with a commission they can’t receive.
IOW: Variable annuities possess an upfront sales charge.
Doug
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Variable vs. Indexed Annuities
One of the newer annuity products over the last decade or so is the equity-indexed fixed deferred annuity. This product accounts for approximately 50% of all fixed annuity sales, and its share is increasing. Because of the current low level of bond yields, fixed annuity returns have been quite low. This product is tied to a percentage of the gain in the S&P 500, but it has one serious limitation. Annuitants do not receive dividends which historically have accounted for about 29% of total return for the Vanguard Index Trust-500 over the past 20 years.
At least this was Peter Katt’s analysis in his original article “Indexed Annuities: Too High a Price for Market ‘Protection’” (AAII Journal, November 1996, pp. 25–27, American Association of Individual Investors, [312] 280-0170).
But, times have changed since then and while participating in only a percentage of the gain in the S&P 500 and not at all in dividends, this product does provide protection against market loss. But, is this protection worth giving up the returns offered by a variable annuity?
Katt then analyzed the returns offered by variable, fixed, and indexed annuities. The results make it clear that most astute investors will conclude that variable annuities were the better choice back then. But – what about in today’s climate?
We believe that the only group of investors that may be better off in indexed annuities are those physicians and medical professionals in their 50s and 60s who are making their final investment push to retirement (five–10 year investment time horizon), and who have little time to earn back any investment mistakes.
Any thoughts?
Dr. David Edward Marcinko MBA CMP™
http://www.CertifiedMedicalPlanner.com
[Publisher-in-Chief]
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More on VAs and Fraud
Most ME-P readers know that I am not a big fan of variable annuities.
But, did you know that Variable Annuities are among the financial products most used to bilk boomers and seniors, according to FA News. In fact, enforcement actions related to VAs more than tripled in 2010 over 2009.
Other common vehicles used by unscrupulous financial advisors are Ponzi schemes, self-directed IRAs and unregistered securities.
Enforcement actions associated with “free-lunch” seminars more than doubled and those with misuse of professional credentials nearly doubled between 2009 and 2010.
Dr. David Edward Marcinko MBA CMP™
[Editor-in-Chief]
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Update on VAs
Dr. Marcinko – Variable annuities are most appropriate for high-bracket taxpayers with income of at least $250,000 because they stand to benefit the most from compounded tax-deferred earnings.
Variable annuities also look more attractive now that high-income investors are nicked by a new 3.8 percent surtax on investment income, and those in the top tax bracket will pay a higher rate on capital gains and dividends, too.
Jasper
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