There are a lot of different types of retirement accounts. Most of them have pros and cons. And there is no “one size fits all” approach when it comes to retirement accounts. Variable annuities certainly have their place. But one of the factors that you must consider when building your retirement portfolio is the order of retirement accounts, this would include variable annuities. But in order to understand this, let me explain what variable annuities are.
(1) How Variable Annuities Work
Variable annuities work pretty much the same way as most other retirement accounts. The main difference is that any kind of an annuity (fixed, variable, or equity indexed) is an insurance product. It is not technically an investment product. But there are a few differences. So let’s point out the different characteristics of how they work.
Deferred Taxes
One of the largest benefits of variable annuities is that they have deferred taxes. Because they are a retirement product, you will not have to pay taxes on the money until you retire. In this way, they work the same as a 401k or other retirement plan.
Invested Money
When you put money into a variable annuity, that money will be invested. The money that is invested is done so in what is called a “separate account”. The separate account is basically a pool of money that the insurance company has that invests your money. The separate account is much like a mutual fund. It is important to note that not all of the money that you deposit into the annuity will be invested. Out of the money that you deposit there will be fees, commissions, operating expenses for the insurance company, etc.
Also, because the money is invested, that means there is a chance for loss. And anytime that there is a chance for loss of your money, the transaction has to be through an actual financial advisor. Someone who only has an insurance license cannot sell variable annuities. They must be sold by someone who has a securities license.
Surrender Charges
This is one of the biggest complaints of variable annuities. They typically have surrender charges. This means that you MUST leave your money in the product for a specified period of time or you will be charged a penalty.
Surrender charges and lengths of time vary by the policy. I have seen them as short as 3 years and as long as 15 years! They typically have a decreasing fee structure to them. Meaning that each year that you leave the money in the variable annuity, there is a smaller and smaller surrender charge imposed on you for pulling the money out.
Here is an example: Nancy deposits $10,000 into a variable annuity that has a decreasing surrender charge fee schedule that lasts for 10 years. Here is what it would look like if she pulled her money out of the variable annuity for each year.
| Year | Surrender Charge | Surrender Amount |
| 1 | 10% | $1,000 |
| 2 | 9% | $900 |
| 3 | 8% | $800 |
| 4 | 7% | $700 |
| 5 | 6% | $600 |
| 6 | 5% | $500 |
| 7 | 4% | $400 |
| 8 | 3% | $300 |
| 9 | 2% | $200 |
| 10 | 1% | $100 |
High Fees
One of the biggest knocks about annuities in general (variable annuities included) is that they have high fees.
On average, fees for variable annuities are about 2.3% per year. Compare that to a 401k, which averages about 1%.
These fees generally include (but are not limited to):
- Commissions (we’ll get to that soon)
- Administrative fees
- Surrender charges
- Mortality expenses
- Investment expenses
- Misc. fees
High Commissions
First of all, let me say this: There is nothing wrong with giving someone a commission. If that person has sold me something and served me in a professional way and has listened to my needs and done their best to meet my needs, I have no problem paying a commission.
However, the commissions for variable annuities are REALLY high. They pay commissions of up to 8% of the contract value PLUS an annual trail commission that is usually around 1% each year.
This will decrease the amount of money that you have in the investment to start with. And pair that with the surrender charges that you would have to pay if you got out of the contract early, it will take you years to break even. And you might not ever recoup the commission and high fees of the product.
No Maximums (Unlike Other Retirement Plans)
One of the really nice things about variable annuities is that there are no annual maximums on variable annuities. This is one of the largest benefits that people see with these products.
Mostly people who have already maxed out all other retirement accounts and want the tax deferred growth of a retirement account look to variable annuities to fulfill that need.
Here is a list of the annual maximums that you can put into a given retirement account in 2022:
| Account Type | Maximum Allowable Contribution (No Catch-Up Provisions) |
| 401k | $20,500 |
| 403b | $20,500 |
| TSP | $20,500 |
| Traditional IRA | $6,000 |
| Roth IRA | $6,000 |
| SEP | $61,000 |
| SIMPLE IRA | $14,000 |
| Variable Annuity | Unlimited |
Gains Taxed at Ordinary Income
When you retire, there are three main ways that your money will be taxed.
- It won’t be (Roth contributions)
- Capital gains taxes (Non-retirement accounts that you have had for more than 1 year)
- Ordinary income
When you retire, it is likely that you will have some of your income taxed at each of these levels.
But with variable annuities, they will be taxed at ordinary income. Yes, you will have tax deferred growth, but you will also pay for that growth with taxes just like you would with a 401k, traditional IRA, or 403b.
Once you have maxed out all of your retirement options, it might be better for you to simply invest into an after-tax brokerage account instead of a variable annuity. That way your growth will be taxed at capital gains (for most people is 15%) instead of being taxed at your regular income level (which will be higher).
No Loss Deduction
One of the more minor drawbacks of a variable annuity is that there is no loss deduction for them. What does this mean?
In a regular investment, if you have a loss, you are allowed to deduct $3,000 of that loss from your taxes. You cannot do this with a variable annuity.
You also cannot do this with any other retirement account either. This is because all taxes gains and losses are deferred until you take the money out at retirement. (That is why it’s called a tax-deferred account.)
So if deducting a loss on your investments is important to you, you would be better off to put your money into an after-tax brokerage account rather than a variable annuity once you have maxed out all other retirement plans that are available to you.
No Stepped Up Basis
This is a big one that most people don’t think about.
When you did and you have money left in a retirement account (401k, 403b, TSP, etc.) and you pass that money on to your heirs, there is what is called a stepped up basis.
This means that your heirs tax basis is whatever they inherited the money at.
For example, your mother puts money into her 401k throughout their working life. She puts $100,000 of her own money into it. With dividends and interest it grows to $400,000 by the time she retires. When she retires, she starts to draw down on that money to live on. Then suddenly she dies and the money is passed to you. When she dies, there is $300,000 left in the account that you inherit.
Your tax basis is now stepped up to $300,000.
That means that you will owe $0 in taxes on the inherited money. So you will only owe taxes on any gains ABOVE $300,000. So if you let it grow to $350,000, you will owe taxes on $50,000 and not the original $300,000.
That is with a normal retirement account.
It is different with a variable annuity. Variable annuities do NOT have a stepped up basis.
In the same scenario but with a variable annuity, your tax basis will be $100,000. The basis is $100,000 because that is the amount of money that your mother put into the account herself. So the IRS looks at the first $100,000 as a return of the money that you put into the account.
Everything above the first $100,000 is taxed at your ordinary income level. So you will owe taxes on $200,000. Ouch.
So if you are in a 24% tax bracket, your tax bill for inheriting a 401k will look something like this:
| Amount Invested | Growth | Total Left in Account | Tax Rate | Taxes Due | |
| Inherited 401k | $100,000 | $200,000 | $300,000 | 0% | $0 |
| Amount Invested | Growth | Total Left in Account | Tax Rate | Taxes Due | |
| Inherited Variable Annuity | $100,000 | $200,000 | $300,000 | 24% | $72,000 |
(2) When to Use a Variable Annuity
As I have stated before, these products can be a useful tool if used in the proper circumstance.
But they should ONLY be used:
- Once you have already maxed out every other retirement vehicle available to you
- If you want even more tax deferred growth than you want to have money put into an after tax brokerage account.
The fees, surrender charges, and commissions are just too high to justify using a variable annuity at any time before you have met these two benchmarks.
(3) Variable Annuities INSIDE of Retirement Accounts
This one is frustrating. I have seen it many times before. Someone who comes to me and they have a variable annuity that is inside of a retirement account (like an IRA or 401k).
Retirement accounts have tax deferred growth. So do variable annuities. You don’t need to have tax deferred growth TWICE!
When you put money into a retirement account, some of the fees are to put your money into a tax deferred account.
Likewise, when you pay some of the fees to a variable annuity, you are also paying for a tax deferred account.
If you have a variable annuity inside of a retirement account, you have paid the same fees TWICE! Don’t do that. There is zero benefit for you.
Final Thoughts
There is a lot here. I know. But it is important to understand how variable annuities work if someone is pitching them to you as a great investment.
As always, you should understand what your money is invested in.
You work hard for your money! Don’t just throw it out the window. Know where it is going. And if you decide to invest in a variable annuity, just make sure that you use the guardrails that I have laid out for you.
You can do it!
Until next time!
0 Comments