30 Jun An Overview of Variable Annuities
Variable annuities (VAs) are an attractive investment, because they offer the ability to invest on a tax-deferred basis, and provide a stream of income that can last a lifetime. VAs, however, can be complex, so all investors should learn the pros and cons of owning these investments. If you’re an insurance professional, use these tips to explain VAs so that your clients can make informed decisions.
When to use a Variable Annuities
Tax-deferred investing allows an investor to compound a larger dollar amount of earnings, which means that the portfolio’s asset balance will grow much faster. If dividend income, interest income and capital gains can be fully invested and not immediately taxed, the portfolio’s total return will be much higher. Tax-deferred investments are taxed when earnings are withdrawn, usually at retirement.
To take advantage of tax deferral, investors should fully fund their 401(k) retirement plan, if a plan is offered through work. This strategy is particularly effective if the employer matches a percentage of the worker’s investment contributions. Once the 401(k) is fully funded, investors should consider funding an IRA account that offers tax deferral. If the investor has additional assets to invest, a VA is an investment option that offers additional tax deferral.
How Variable Annuities Work: The Bucket Analogy
Understanding VAs can be simplified through the use of the bucket analogy. Assume the bucket contains the VA’s assets, and the investor fills the bucket by making premium payments. Because an annuity is an insurance product, the invested dollars are referred to as premiums.
When the investor adds premium payments to the bucket, the investor can choose from a group of stock or bond portfolios, or invest in a fund that pays a fixed return. The interest income, dividend income and capital gains all remain invested in the bucket, since they are not taxed until dollars are withdrawn from the annuity.
The VA is registered as a security with the Securities and Exchange Commission (SEC), and the advisor who sells an annuity must carry both an insurance license and a securities license.
There are several choices that allow the investor to cut a hole in the bottom of the bucket and withdraw funds, and one choice is to annuitize. Annuitization means the investor stops adding premiums and decides to take a stream of payments until the bucket is empty. The annuity payments can be over a set number of years, or over the life of the annuitant. One big advantage of purchasing an annuity is that the investor can decide to take a stream of payments that the annuitant cannot outlive, and this is a great choice for retirees. Once payments begin, the annuitant is taxed on the portion of each payment that is considered earnings, and any return of premium payments invested is not taxed.
An investor can also cut a hole in the bucket and take a withdrawal, and this choice does not require the investor to annuitize. The bucket remains open, and the investor can continue to add premium payments. The earnings are taxed, and may also be subject to a 10% penalty for those under the age of 59½.
Investment risk is the risk that the stock and bond investments in the portfolio decline in value, and VA buyers are exposed to this risk. Investors should think carefully about the amount of risk they are willing to take before choosing specific subaccounts (investment portfolios) in an annuity.
VAs also carry a variety of fees to cover the cost of managing the investment portfolios and the cost of the insurance component of the annuity. Investors typically pay a sales charge when they invest premiums, and investors are subject to surrender charges for taking withdrawals. The VA owner will also pay annual fees for portfolio management.