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Is an Annuity For You? Look at All Factors Before Buying

By: Christine Dugas
Source: USA
Date: 5/29/03

Why pay taxes now if you can put off paying them until much later? All things being equal, the answer is easy.

But in the new tax law, all things are not equal. Now that Congress has reduced taxes on capital gains and dividend income, taxable investments don't look so bad. And tax-deferred vehicles, like annuities, have lost some of their luster. That's because the gains on money held in an annuity or an IRA continue to be taxed as ordinary income when withdrawn. Under the new law, the top income tax rates have been pared to 33% and 35%. But by contrast, the top rates on capital gains and dividend income have been cut to 15%.

At issue: Will the benefit of tax-deferred compounding over time outweigh the lower tax bill on capital gains and dividends? (related table - tax deferred versus taxable income)

Experts say that if you can put pretax money into a tax-deferred account, such as a 401(k) or IRA, you'll always be ahead of the game. But it's less clear whether you'll benefit from putting after-tax money into an annuity or non-deductible IRA.

"Before the tax change, I wouldn't recommend an annuity to too many people," says Richard Venegas, a financial planner in Escondido, Calif. "But the new tax law shrinks the pool even further."

The Tax Impact

The new tax law doesn't dramatically alter the merits of a tax-deferred annuity, many experts say. But on balance, it means that it will take longer for most investments held in an annuity to reach the break-even point, when after-tax value starts to exceed the value of the same investment in a taxable account. If you can't keep your money in an annuity for at least that long, it might not make sense to consider one.

For example, under the old tax law, it would have taken a $10,000 investment in an equity-income mutual fund held in a variable annuity eight years to reach the break-even point, according to an analysis by mutual fund company T. Rowe Price. That assumes the fund earned an 8% average annual return, and the investor was in a 27% federal tax bracket.

Under the new tax law, it would take 10 years longer, or 18 years, for the same fund to break even, assuming the investor is in the 25% federal tax bracket.

The amount of time necessary to reach break even will vary according to the investment. T. Rowe Price found that under the old law, it took 12 years for $10,000 invested in a growth fund held in a tax-deferred account to reach the break-even point. Under the new law, it took seven years longer, or 19 years, to break even.

Annuity expenses could add to the break-even time.

The Features

Variable annuities have become popular as a way to save for retirement. Sales peaked at $137 billion in 2000, according to the National Association for Variable Annuities (NAVA). Last year, sales were $114 billion, virtually unchanged from 2001.

Though many people are attracted to the tax shelter offered by variable annuities, they often don't fully understand the complexities. Variable annuities are essentially an insurance contract that holds a number of tax-deferred investment options. Unlike a non-deductible IRA, there are no restrictions on the amount you can contribute.

An annuity typically offers owners several payout options, such as a lump sum or the option to receive equal periodic payments for the rest of their life. "The real value of annuities is not tax deferral, but the ability to lock in a lifetime stream of income," says Robert Nestor, principal at Vanguard Annuity and Insurance Services.

Most annuity contracts provide a death benefit if the owner dies during the accumulation phase. It typically guarantees that the beneficiary will receive an amount equal to the principal invested even if the value has declined.

In some states, investments held in a variable annuity are protected from creditors. And for purposes of college planning, money in an annuity might reduce available assets and help you qualify for financial aid.

Be aware that you might face a 10% penalty if you withdraw money from a variable annuity prior to age 591/2. And variable annuities typically include surrender charges that are levied if you withdraw money during the first years of the annuity contract.

The Fee Trap

There are a few low-cost variable annuities available directly from companies such as Vanguard, Fidelity, Charles Schwab and TIAA-CREF. But variable annuities typically come with high fees that can drag down the return and add to the time it takes for the investments to break even.

Expenses can range from 2% to 3% per year, on top of loads and commissions, according to a report last year from Charles Schwab. That can take a big bite out of potential return.

For example, if you invest $600,000 in a variable annuity that charges 2.75% in annual expenses and your neighbor invests the same amount in an annuity with 1.5% annual expenses, and you both earn 6%, after five years, your investment would be worth $43,662 less than your neighbor's, according to a Schwab analysis.

Who's a candidate?

Given the pros and cons of a variable annuity, who should consider one? A variable annuity is a product suitable for a long-term investor who is saving for retirement and has already maxed out on 401(k) contributions or other tax-deferred retirement saving options, says Mark Mackey, president of NAVA.

At a minimum you should have 10 years before you'll need to begin tapping into the money and another 10 years or more before you'll complete withdrawals, says Harold Evensky, a financial planner in Coral Gables, Fla. That way, much of your money will have a 20-year span in which to grow tax-deferred. Some people argue that you need an even longer time horizon, given the tax change.

Ideally, you should be in a high tax bracket, and have money that you can afford to lock away until you're 591/2.

Wise investing

If you already own a variable annuity or are considering one, you should use it to invest in options that produce a lot of taxes and reserve tax-efficient investments, such as index funds, for your taxable accounts. For instance, a variable annuity would be a good vehicle for actively managed stock funds, says Rande Spiegelman, vice president of financial planning Charles Schwab.

Other types of tax-inefficient investments to consider include funds that invest in real estate investment trusts, high-yield bond funds and zero-coupon bonds, experts say.

As you analyze your options, keep in mind that the current tax cuts are temporary. Unless reauthorized by Congress, they are scheduled to expire at various points over the next decade. "Ultimately, the investment decision should come first," Spiegelman says. "Congress likes to monkey with the tax law. All you can do is position yourself as tax efficiently as you can."

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