From The Portsmouth Herald, October 8, 2010
Money Talk: Deferring taxes can boost returns, but watch for traps
By David T. Mayes, MA, EA, CRPC(R), CFP(R)
So far this year nearly $68 billion has poured into variable annuities, up 8% from 2009. Investors seeking to stabilize their retirement prospects are drawn to the promise of deferred taxes, investment growth, downside protection and lifetime income.
While immediate annuities may make sense for retirees who do not want to leave their monthly income to the whim of fluctuating stock and bond markets, the variable annuities attracting investor dollars today are a different animal. These contracts can be turned into a guaranteed income stream at some point, but they are generally purchased as a vehicle for accumulating assets, not distributing them. They fall into the deferred annuity category – the investor turns over a lump-sum or makes periodic investments that are left to grow for future needs. Purchase payments are akin to non-deductible IRA contributions. There is no up-front tax break for the contribution, but the earnings growth within the contract is not taxed until withdrawn.
Paying taxes on dividends when they are received or on capital gains when you sell winning positions creates a drag on your portfolio's performance. Deferring tax on investment income can be good, but it takes time for the advantages to show up in your account balance. Typically, an investor must hold an annuity for 10 years or more for the tax benefits to outpace a taxable account. Annuities also carry mortality and expense charges that can offset the tax-deferral advantage.
In addition, withdrawals from annuities are taxed as ordinary income, even if generated from qualified dividends or capital gains. Current law taxes these investment income sources at a maximum rate of 15%. Investors in tax brackets higher than this will lose this tax advantage when sheltering investments inside a variable annuity. If the Bush tax cuts are allowed to expire as planned at the end of this year, annuities will look more favorable - capital gains will be taxed at 20% and dividends will be taxed as ordinary income at a top rate of 39.6%.
So should you consider purchasing an annuity to supplement your other tax-deferred accounts? If your 401(k) and IRA contributions are maxed out, adding an annuity can work if you are in a high tax bracket now and expect to be in a lower bracket during retirement; the annuity has low fees; and you plan to load the account with income generating investments such as taxable bonds. Annuity withdrawals will not escape the 3.8% Medicare surtax that will be levied on investment income starting in 2013.
Granted, most variable annuities are purchased for the guarantees they offer against market declines, not tax deferral. For an additional charge, annuity investors can secure the promise that they can withdraw a fixed percentage of their account each year for life. These guarantees may also periodically lock in gains so that growth is not lost to market declines just before it is needed for income. Adding these features can push the cost of your contract to over 4% per-year including investment management fees, raising questions about whether such guarantees are really worth the cost.
If guaranteed retirement income is your objective, it may pay to accumulate your nest-egg in a taxable account using tax management techniques such as tax-loss harvesting and selecting tax-efficient mutual funds. This way, you can take advantage of lower capital gains tax rates as you go. At retirement, these funds can be used to purchase an immediate annuity which will provide lifetime income.
If you already own a variable annuity, a review of your policy may be in order to see if lower-cost options are available. While surrendering your contract will trigger tax on accumulated gains, you can trade-in a high-cost annuity without paying tax via a 1035 exchange. Be sure to read and understand your existing contract first. Your current insurer may impose a surrender charge on the switch and, if your account has lost value, you may be giving up locked-in withdrawal or death benefits that you have already paid for. These guarantees cannot be transferred to your new policy so tread carefully.
David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Agent at Mackensen & Company, Inc., a fee-only advisory firm in Hampton. He can be reached at (603) 926-1775, firstname.lastname@example.org or by visiting www.mackensen.com.