Variable Annuities Receive Scrutiny

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, June 11, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Part one of a two-part series

Variable Annuities Receive Scrutiny

The Securities and Exchange Commission, concerned with the complexity, risk and costs of variable annuities, has issued an "investor alert" and on-line brochure, "Variable Annuities: What You Should Know." (http://www.sec.gov/consumer/varannty.htm). Spurred on by high commissions, annual sales of variable annuities amounted to $120 billion last year, a 20% increase from 1998.

The financial community thinks it is better to invest directly in a mutual fund, but do variable annuity benefits outweigh their higher costs, as claimed by the insurance industry?


An annuity is a contract between you and another party, usually an insurance company. In general, you invest a lump sum or installments and the company agrees to make a series of future payments to you, usually when you retire, at regular intervals for the remainder of your life.

A variable annuity is a special contract offered by insurance companies: It is similar to a mutual fund, but is wrapped with an insurance "death benefit." Its value depends on the growth of your individual investment. Generally, future payments are determined by a combination of your investment’s value and your life-expectancy at the time you begin receiving payments.

Because the variable annuity is considered an insurance product, it operates much differently than a mutual fund. First, variable annuities are tax-deferred; you pay no taxes on your investment gains and earnings until you begin receiving payments. Note: There are tax penalties for early withdraw that are similar to those imposed on IRAs.


A variable annuity works like this: (1) you make non-deductible purchase payments under the contract; (2) the money is typically invested in mutual funds; (3) the earnings from the investment grow tax-deferred; and (4) the payments to you are taxed as ordinary income, except for the portion you invested with the company. For example, if you invested $20,000 with the company and the annuity is worth $100,000 when the payments begin, then 80% of the payments will be ordinary income and 20% a tax-free return of your investment.

Note: Since retirement plans grow tax-deferred anyway, purchasing a variable annuity through a retirement plan offers no additional tax advantage.

The downside to the variable annuity’s tax deferral is that earnings and growth are taxed as ordinary income, not at the lower capital gains rate, regardless of how long you’ve held the investment. With a direct mutual fund investment, you report long-term capital gains on distributions from the sale of stock held 12 months or longer.

Second, variable annuities are designed to give you a consistent income stream for the rest of your life (or the combined life of yourself and your spouse or other beneficiary); thus, the longer you live, the more advantageous a variable annuity becomes. Of course with a mutual fund, you could deplete your entire investment during your lifetime.

Many variable annuity contracts, however, require a fixed payment schedule that cannot be changed, regardless of your personal circumstances. In contrast, an IRA has a minimum payment schedule (you may always take more than the minimum) and mutual funds have fewer and less expensive withdrawal restrictions.

Third, variable annuities offer a death benefit should you die before receiving your scheduled pay-out. The death benefit is typically the amount you’ve paid to the company, although some policies may offer greater benefits. This benefit protects your estate in case your investment is worth less than what you’ve paid into it. This is attractive to those who would not otherwise risk investing in the stock market (those who invest in savings accounts or certificates of deposit).

Note: Because stocks have historically gained value over the long term, many financial advisors believe this insurance feature is worthless. Also, the SEC has warned investors about dubious "bonus" features offered in some variable annuities that are outweighed by higher expenses. For example, a small credit applied to the purchase payments may be offset by higher penalties for withdrawals.

Next Column: Tax consequences and drawbacks to annuities



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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.