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Does Your Tax Shelter Leak?

04/30/01 05:31:56 PM PST
by Morley Hudson

Variable annuities offer an attractive tax shelter, but don't let that inviting fact blind you to potential booby traps.

Variable annuities have long been a favorite marketing tool for salespeople, and for good reason. Who wouldn't want a tax-deferred mutual fund wrapped in an insurance policy - a fund that's guaranteed to generate a set amount of income in the future and may yield even more, depending on the performance of the underlying equity instruments? But before a broker, financial advisor, financial planner, or salesperson convinces you to buy or transfer a variable annuity, investigate your options and evaluate the major differences among them.


In the world of variable annuities, there are various facts and features to be aware of, among which are:

  • Never buy a fixed-income annuity unless the initial percentage interest rate is guaranteed for five years or more, because the first year's percentage is quoted at a very high and attention-grabbing rate, but the rates of the second and subsequent years are much lower. By demanding a guaranteed five-year rate, the prospective buyer gets down to the real interest rate he has to live with - not the teaser rate.

  • Find a fee-only investment manager. There's no point in owning a tax-sheltered investment without having someone actively manage your investments. Make sure the manager has a record of high annual gains with mutual funds and uses an active fund rotation strategy. Paying 2% a year or less is dirt cheap for double the annual rate of return - or more - of any asset allocation selection of funds (including index funds) that you, the salesperson, or a friend can concoct. Any actively managed fund selection and rotation strategy will double any asset allocation return (in fact, asset allocation formulas frequently end up with losses for the year; 2000 was a prime example).

    Check out these websites for information on variable annuities.

  • Make sure the manager you choose also handles the subaccount mutual funds (also known as clone funds) included in variable annuities. (A subaccount or clone is modeled after a retail mutual fund; your variable annuity investments are invested in these subaccounts or clones.) You want your variable annuity subaccounts in the best-performing funds, just like you would your individual retirement account (IRA), KeoghY, 401(k), or other tax-sheltered retirement plan. The daily pricing data on subaccount funds is different from the pricing of retail mutual funds whose prices can be found in financial newspapers such as The Wall Street Journal. The clone version performs differently, and generally better than its retail big brother, because it is smaller in total asset size and thus can be more nimble in stock selections. In addition, the daily prices of the same clone fund vary between different variable annuities because each clone fund started on a different date and with a $10 per share starting price; the chart of daily prices will be the same for each specific clone fund, no matter which variable annuity offers it. As a result, technical analysis tactics can be safely used for selection, tradeup, or rotation. Annual operating costs of the clone funds are usually the same as those of their sibling, the retail mutual fund, so this ends up being a wash.

  • This cannot be underemphasized: Using an investment manager is a must and easily worth the annual management fee. Very few variable annuity investment managers use variable annuities' cloned fund pricing data, which is not the same as the retail version pricing.

  • Never buy an annuity as part of your IRA, Keogh, or other retirement plan. You already have the tax shelter and so will lose the stretch out, which is the advantage of beneficiaries being able to use their own life expectancy for minimum required distributions in an IRA. For example, a one-year-old grandson beneficiary can use 86 years to withdraw required IRA distributions, whereas a variable annuity limits the distributions or withdrawals to 20 years. (However, never take the life annuity option, since all assets go to the insurance company in event of a premature death.)


    Costs associated with variable annuities can be high due to the features and options involved, so before you buy any, evaluate the following features against competitive proposals:

  • Sales cost - Is the variable annuity load or no-load? If it's load, is it front-loaded or rear-loaded? Commission fees to salespeople and the broker/dealer firm can range from 3% to 8% or more and impose surrender charges so the insurance company can recover the sales fees already paid out if the owners surrender the policy during the first six to 10 years. Note that no-load variable annuities do not have sales costs nor surrender charges; this is the only difference with the load version, and some issuers offer both types.

  • Surrender charges - These are charges you must pay if you decide to redeem an annuity. Surrender charges decrease by approximately 1% every year up to 10 years, but five to seven years is a more typical time span to redeem a load annuity.

  • Mortality and expense annual cost (M&E) - This charge is the major difference between variable annuity policies. It ranges from 0.40% to 2.80% annually of the total value of the contract and is deducted daily. This cost represents the operating cost and profit to the insurance company issuing the annuity, plus a very modest cost associated with the death-benefit guarantee (only the initial invested amount is guaranteed as a death benefit, not the cash or market value of the policy at the time of death of the owner and/or annuitant). M&E is deducted from the gross value of the separate accounts combined. When value gets into the bigger numbers ($500,000 and up), these costs become burdensome and reduce the total return. Beware of the bonus credit features currently offered; these are annuities in which a percentage will be credited to your account. Although this increases the value of your investment, this bonus may carry higher fees or a longer surrender period.

  • Selection - Is the stable of mutual funds being offered capable of achieving the highest annual total return? Determining this is critical to maximizing tax-sheltered gains, which are the primary sales feature for variable annuities. You may want to transfer to another company's variable annuity contract for a better choice of funds or other features, such as death distribution options. Death distribution options vary among issuers; a critical factor is whether the variable investment feature with the stable of funds is terminated at any time and only a fixed-income option is available. This also applies to choosing some annuitizing option by the annuitant. Never, ever annuitize an annuity; always use the withdrawal feature to assure retaining the variable investment feature and to assure maximum benefit to your beneficiaries in event of your death with assets still in the contract. You can transfer or switch to another company's contract without any tax consequences by using IRS Form 1035, which will be supplied with the application.


    An additional benefit of variable annuities is that numerous options are available. These are as follows:

  • If the beneficiary is a surviving spouse, he or she becomes the owner and annuitant and can name beneficiaries, make periodic withdrawals, or elect one of the annuitization options. (An annuitant is usually but not always the owner of the annuity; for example, if he or she is incapable of making decisions, the owner will make them.)

  • If the beneficiary is not a spouse, the options include lump-sum payout; five-year payout; lifetime annuity (early or premature death of the beneficiary results in the value of the contract going to the insurance company); or lifetime with 20 years certainY, which is an annuity with income payments for 20 years. (See sidebar "Variable annuity options for withdrawals.") Only a few variable annuity contracts offer the 20-year certain feature, but it is the best choice unless a refund life annuity is offered. Refund life annuities will make distributions or withdrawals on a regular basis and of a certain amount (recalculated every year) to a beneficiary or his/her subsequent beneficiaries until all proceeds of the contract are depleted. With the 20-year certain, the company would evaluate the value of the contract each year and adjust your annual payment to reflect current value. In addition, payments or distributions would continue beyond the 20 years to eat up the contract value and finally stop when the contract became worthless or the beneficiary died. (Internal Revenue Service regulations require that regular payments start at the death of the annuitant or owner.) In contrast, some contracts allow the beneficiary in turn to name his or her beneficiary.

    Unless the stretch-out options, which provide the longest possible payout to a beneficiary, are offered with variable investment continuing to the beneficiary, tax loss by the beneficiary is the biggest booby trap in this investment vehicle, as it has been with traditional IRAs prior to the new 2001 changes in the regulations. This is because all payments from a variable annuity are ordinary income, regrettably, and subject to the appropriate income tax.


    From my experience, the no-load variable annuity offered by Charles Schwab & Co. and discount broker T.D. Waterhouse (formerly Jack C. White Co.) and the front-end load annuity by Nationwide Insurance's "Best of America IV" best meet the criteria I have outlined. One investment manager produced these results:

    With these kinds of investment results, a variable annuity contract starting with $50,000 and 18% ARR would double every four years.


    Unfortunately, a financial advisor or planner only has to say "tax-free" and too many people simply reply, "Where do I sign up?" Variable universal life insurance owned by an irrevocable trust is the only estate and income tax%ADfree equity or stock investment vehicle available. (For other articles on variable life insurance, visit www.working-money.)

    Variable annuities do offer advantages such as tax-deferred earnings, professional management, and flexible payout options. Above all, before jumping into a variable annuity, be aware of all the costs and beneficiary options.

    Morley Hudson is a mechanical engineer and former Louisiana State Representative. He is a retired estate executor, trust manager, and investment manager.


    Hudson, Morley [2001]. "Shake Uncle Sam Off Your Coffin," Working Money, Volume 2: May.


    Systematic withdrawals prior to age 59-1/2 are normally subject to a 10% penalty tax except if substantial, equal periodic payments are taken. Thus, payments must be made at least annually, continue for at least five years or until the recipient reaches age 59-1/2, and assume no more than a "reasonable" level of interest or investment return.

    Any company will supply a printed payout schedule on these withdrawals. Here's an example showing payout schedules for a $140,000 contract for two individuals. They are based on 0% and 5% interest but could be any interest rate between 0% and 9%.

    Nancy: Age: 51
    0% provides $5,166 annually
    5% provides $9,089 annually

    Courtney: Age: 42
    0% provides $4,005 annually
    5% provides $8,146 annually

    The variable investment feature would continue during this systematic withdrawal time interval.

    When the annuitant/owner dies, the beneficiary has these options:

  • Full lump-sum death benefit

  • Five-year payout of death benefit

  • Annuitization

  • The life annuity is paid during the lifetime of the beneficiary, but with his/her/their premature death, the remaining value of the contract goes to the insurance company.

    A life annuity with 10- or 20-year payments guaranteed or certain means that payments would continue beyond any premature death of the beneficiary (that is, less than life expectancy) to his/her named beneficiary.

    None of the annuity options can exceed the life expectancy of the beneficiary at his or her age during the year the annuitant and/or owner dies.

    Some insurance companies offer the option of either a fixed (specific interest rate) or variable (investing in the stable of mutual funds) payout to the beneficiary. Unfortunately, many only offer the fixed payout. One of the largest insurance companies reverts from the variable investment to the fixed as soon as the annuitant or owner dies; other insurance companies do this when the annuitant selects an annuity option or annuitizes. Run, do not walk, away from this type of policy.

    Be aware that many life insurance companies change from the variable investment method to the fixed interest rate investment option, regardless of what you selected. It is critical to get this information confirmed in writing by the death benefit or payout department of the insurance company. Make sure the statement is countersigned by an officer of the company. So far, two companies have changed their tune and not backed their representatives' statements at the customer relations level.

    When the annuitant (or owner in some contracts) dies, the key questions to be addressed are:

  • What options does the beneficiary(s) have for extending payments beyond the certain period to use up the contract's value?

  • Does the variable investment procedure continue as it was in the original contract?

    If either or both are in the negative, then consider transferring to another variable annuity contract with an insurance company that offers policies that answer positively to both questions.-M.H.

    Copyright © 2001 Technical Analysis, Inc. All rights reserved.

  • Morley Hudson

    Address: Undisclosed
    Shreveport, LA 71106
    Phone # for sales: 318 868 9405
    Fax: 318 868 6555
    E-mail address:

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