The array of products and services available in the financial marketplace today is enough to bewilder even the expert, and there are very few vehicles that have generated as much controversy in both public and professional forums as variable annuities. Many brokers and planners view them as indispensable retirement planning tools, while other financial experts warn consumers to avoid them at all costs. Of course, there is no black-and-white answer to this issue, but you need to understand the advantages and disadvantages of these investment vehicles before making a decision.

Pros of Variable Annuities

  • They aren’t subject to contribution limits.

  • The money in them grows tax deferred.

  • Many states protect them from creditors.

  • They are exempt from probate.

Cons of Variable Annuities

  • They can end up generating significant taxes.

  • They usually come with high fees.

  • They are so complex that many who own them don’t understand them.

How Variable Annuities Work

One of the problems that you face when it comes to variable annuities is the difficulty in understanding how they work. Variable annuities probably rank second only to variable life insurance in terms of complexity. They resemble their fixed and indexed cousins in that they are issued as contracts that grow on a tax-deferred basis regardless of whether they are placed inside an individual retirement account (IRA) or another tax-deferred retirement plan. There is a 10% early withdrawal penalty for distributions that are taken before the contract owner is 59½, with certain exceptions for death, disability, or other factors.

However, variable contracts are unique in that they offer a preselected group of mutual fund subaccounts into which you allocate the premiums paid. The values of the funds rise and fall with the markets, with no guarantee of principal. Most variable products also contain living and death benefit riders that guarantee either a minimum account value or a stream of income (see below). Nevertheless, even this information is not enough to allow you to make an educated buying decision. You also need to know the pros and cons of these unique products.

Variable annuities can provide superior returns over the long haul, but it is prudent to learn about the tax treatment of this financial product before you invest.

The Advantages of Variable Annuities

Variable annuities can offer a package of benefits that are, for the most part, unmatched by any other type of financial product on the market today. Their main selling points include:

Unlimited Contributions: As mentioned previously, there is no limit to the amount of money that can be placed inside a variable annuity. For this reason, they are popular with wealthy investors who are looking for tax shelters. (Most carriers will impose a proprietary limit for initial purchases.)

Tax Deferral: Like all other forms of annuities, variable annuities grow on a tax-deferred basis. Only the distributions are taxable once they are made.

Insurance Protection: Most variable contracts today offer an array of living and death benefit riders that promise a guaranteed stream of income or else a minimum account value. The living benefit riders will pay out a guaranteed stream of income that is based upon a hypothetical guaranteed rate of growth from the subaccounts. You will still get this payout even if the subaccounts lag this rate of growth. The typical death benefit rider today promises the beneficiary the greatest among the current contract value, its highest value on the date of the contract anniversary, or a value based on a guaranteed hypothetical rate of growth.

Potential for Superior Returns: If you hold variable annuities for the long term, you can reap the commensurate growth in the fund subaccounts over time. People who put their money in stock subaccounts and leave it there for 20 years or more will probably see a higher return on their investment than can be had from any other type of annuity. Most variable contracts also offer basic money management services, such as periodic rebalancing. The fixed accounts that are available in many variable contracts are also often higher than the rates offered by comparable fixed products.

Avoidance of Probate: As with fixed and indexed annuities, variable annuity contracts are unconditionally exempt from probate, allowing beneficiaries to get their money quickly.

Protection From Creditors: Although this benefit varies somewhat by state, many states mandate that all monies that are placed inside variable or other types of annuity contracts cannot be attached by creditors.

Initial Bonuses and High Guaranteed Rates: Many variable annuity contracts will pay an instant bonus on money that is paid into the contract, or they may offer a dollar-cost averaging program that pays a high fixed rate on the initial balance and then moves the money into the subaccounts that you choose over a set period of time, such as six or 12 months

The Disadvantages of Variable Annuities

Despite their versatility, variable annuities are not all things to all people and do have some real limitations. Critics of variable products are quick to point out the following shortcomings that come with these contracts:

Poor Cost Basis: Unlike stocks or other securities, the cost basis of variable annuities does not step up when they are inherited. Beneficiaries will pay tax on the entire contract value that has grown from the date of the initial purchase.

Poor Tax Treatment: Although variable contracts grow tax-deferred until retirement, they impose the same 10% early withdrawal penalty as traditional IRAs and qualified plans. All distributions from these contracts are taxed as ordinary income unless the contract was placed inside a Roth IRA or retirement plan. Capital gains treatment is not available. A similar long-term investment in index funds that do not pay dividends could yield similar growth, but with total liquidity and lower taxes on long-term gains.

High Fees: Variable annuities are one of the most expensive financial products in the marketplace. They come with myriad fees and charges, including mortality and expense fees, mutual fund subaccount management fees, contract maintenance fees, and other miscellaneous costs. Some contracts will charge transaction fees after a certain number of transactions have been made within the contract. Living and death benefit riders also subtract periodic fees from the contract balance. Most contracts also come with a substantial back-end surrender charge schedule that may not expire for 10 years or longer.

Complexity: As mentioned previously, variable annuities are one of the most complicated financial instruments available today, and they are often poorly marketed and understood by both salespersons and consumers.

The Bottom Line

Variable annuities can offer you many benefits that may require the simultaneous use of several other types of investments and accounts to duplicate, but you need to be thoroughly educated on their drawbacks by brokers and planners.

The value of these products can only be evaluated in the context of your tax situation, investment and retirement objectives, and time horizon.