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Variable Annuities for Tax Planning

Rebecca writes in to ask,

“Because of my work (I’m a physician), I’m in a high tax bracket (33% federal). I was recently contacted by a financial advisor who suggested a variable annuity as a way to minimize my taxes because the growth in a variable annuity is tax-deferred. I’ve also heard plenty of bad things about variable annuities though. What do you think? Would an annuity be useful in my situation?”

First let’s cover some background information to make sure we’re on the same page.

How Deferred Variable Annuities Are Taxed

You are not taxed on growth that occurs within a variable annuity. You are taxed, however, when you take money out of the annuity.

How you are taxed depends on whether or not you have “annuitized” the annuity. (To annuitize an annuity is to convert it to a series of substantially equal periodic payments over a specified period — the rest of your life, for instance.)

If you have not annuitized the annuity, distributions of earnings will be subject to ordinary income tax, while distributions of the original cost of the contract are tax-free. Note, however, that distributions are assumed to come from earnings until all earnings have been withdrawn.

If you have annuitized the annuity, distributions will be partially taxable as ordinary income and partially tax-free. The portion that is non-taxable is calculated so as to return the original cost of the annuity to you, without taxation, over your life expectancy. If  you live long enough to receive the original cost of the annuity tax-free, any remaining payments will be entirely taxable.

Finally, distributions from a variable annuity prior to age 59½ will also be subject to a 10% penalty — with a few exceptions.

Note: All of the above assumes that the variable annuity is not held within a qualified retirement plan such as a 403(b). If the annuity is held within such a plan, the annuity will be taxed just like anything else in the plan. (In other words, you get no additional tax benefit from using an annuity within a qualified retirement plan.)

When Are Variable Annuities Useful for Tax Planning?

While variable annuities do have the benefit of tax-deferral, they have two major disadvantages.

First, they’re expensive. According to Morningstar, the average variable annuity (without any optional riders) costs 2.42% per year. Even at Vanguard, the average variable annuity costs 0.59%. This is in contrast to index funds or ETFs, which can be found for less than 0.20% per year in most asset classes.

Second, they turn income that would ordinarily be taxed at advantageous rates (e.g., qualified dividends and long-term capital gains) into ordinary income.

Because of these two drawbacks, variable annuities generally aren’t beneficial as a tax planning tool for most investors. In general, the only time they should be considered for such purposes are when three conditions are met:

  1. You have already maxed out your contributions to IRAs and qualified retirement plans,
  2. You’ve filled up your tax-advantaged accounts with your least tax-efficient asset classes (e.g., REITs and high-yield bonds), and
  3. You still want to own more of those asset classes (such that they’d have to go into a taxable account or a variable annuity).

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  1. Agreed. Variable annuities aren’t beneficial as a tax planning tool for most (just about all) investors. Salespeople often target high earners with the pitch that it’s a good tax move once IRA and retirement plan contributions are maxed. But there are other, less costly tax moves.

    People also often overlook prepaying their mortgage before looking for tax shelters beyond IRA and their employer’s retirement plan. Prepaying a mortgage can save tens of thousands of dollars. Folks should compare that savings to amounts they think they can save (net of fees) making systematic contributions to a variable annuity.

  2. Mike,

    I like your response. I’d only add that in the case of scenarios 1, 2 and 3 a low cost tax efficient portfolio of index funds would likely still be a better option than most variable annuities out there. This is especially true if you’re buying equities, but may also hold true for municipal bond holdings and possibly taxable bonds.

    Bottom line: Variable annuities (and whole life insurance too) should generally be the last place to put savings after all other savings options have been exhausted– their value, after costs, may not be better than just saving in a taxable account.

  3. Dylan, good point re: prepaying a mortgage as a good way to use up any savings amounts beyond what can be invested in a tax-efficient way.

    Sailor, thank you for sharing your thoughts. By the way, in case it wasn’t clear, my numbered “1, 2, 3” list above wasn’t intended to be three separate scenarios, but rather three conditions all of which must be met before VAs should even be considered for tax planning. (Editing the article now to make that more clear — just to be on the safe side.)

  4. Thanks Mike for looking out for us docs!

    In general, variable annuities are a product made to be sold, not bought. Vanguard has one that is RELATIVELY low cost, but ABSOLUTELY a fairly high cost that is useful for someone who has already been suckered into a VA to roll over into.

    But if you have the choice to start one or use a taxable account? I’d go with the taxable account. There are lots of tax advantages in a taxable account, even for those highly paid doctors (who might not be so highly paid if that Medicare doc fix doesn’t go through this month).

    You can read more about taxable accounts here:

    What’s worse is a lot of “advisors” push docs into VAs for the high commission BEFORE they’ve maxed out their 401K and backdoor Roth IRAs. Shame on them.

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