Tax Implications of Variable Annuities

Variable annuities offer tax-deferred growth.

If you’re considering a variable annuity as an investment option, make sure you and your advisor discuss the tax implications. Variable annuities are insurance contracts that offer a choice of underlying investment options for your retirement savings. Investors make deposits into a variable annuity contract and then direct the insurance company to place the money into various investments, which may include stock, bond, and money market funds. Since variable annuities offer flexibility in choosing investments, they are a popular choice for tax-deferred growth.

The main advantage of variable annuities is that dividends, interest, and capital gains aren’t subject to current taxation. Taxes are deferred until the money is withdrawn, at which point taxation occurs only on the gain from the original investment in the contract. Tax-deferred compounding allows you to accumulate more money over the long term through a variable annuity than you would through non-tax-deferred investments. An additional advantage is that you can sell investments within the annuity and lock in gains without triggering an immediate tax.

Saving through compounding

When taxation does occur, however, the gain is taxed as ordinary income, even if most of the gains were capital gains. This is a potential disadvantage because if the money had been directly invested in stocks outside of the variable annuity, the capital gains tax rate would be no more than 20 percent for investments held more than one year. For long-term investors with a low-yielding growth portfolio, holding assets outside a variable annuity may produce a lesser tax burden, especially for those in high income tax brackets.

In addition, owners of variable annuities cannot deduct losses on investment transactions within the variable annuity. If the variable annuity owner takes a hit on a stock fund within the annuity, he or she won’t be able to deduct the loss of investment value. Finally, owners of variable annuities should consider these vehicles to be long-term investments since withdrawing money before age 59-1/2 results in a 10 percent federal tax penalty.

Despite the tax consequences discussed above, variable annuities hold several tax advantages over direct investment. For instance, the longer the tax deferral, the better off an investor may be in a variable annuity. Also, a bond portfolio that emphasizes income may produce better results in a variable annuity, since the income can be shielded and can continue to grow tax-free until withdrawal. Investors who trade frequently may be better off in a variable annuity as well, as their short-term capital gains through direct investment might be more painful than the eventual income taxes that would be paid upon withdrawal from a variable annuity.

Although tax deferral is an attractive aspect of variable annuities, beneficiaries are prevented from enjoying continued tax deferral over an extended period of time. In addition, they must accept minimum distributions from the decedent’s variable annuity, though requirements depend upon whether the annuity owner had begun to take distributions. There are exceptions, such as allowing a surviving spouse beneficiary to defer taxable distributions during his or her lifetime.

Note: some companies also offer IRA annuities. Since. an IRA already offers tax deferral, placing a variable annuity in an IRA doesn’t result in any additional tax-deferred growth. Instead, it could result in higher expenses and surrender charges.

Estate Planning Considerations

Assets held outside a variable annuity usually enjoy a step-up basis upon death, but no such step-up is available for variable annuities. Beneficiaries of variable annuities are subject to both estate and income taxes on distributions.

While the tax deferral of variable annuities is appealing, investors should consider their time frame and the type of investments they want to make. They should also consult an advisor regarding related tax advantages and disadvantages.