Business Matters Variable annuities: retirement security, investment options

By Kevin FitzGerald

Following the advice given to me many years ago, I have always put the maximum available into my retirement accounts. Now that I have put my children through college, I am looking to enhance my retirement funds as much as possible. A friend of mine suggested variable annuities, but I’m not sure how they work, could you explain?

D.W., Park Slope

Is your investment portfolio reeling from the one-two punch of higher taxes and low interest rates? Are you looking for a way to potentially increase investment earnings, while minimizing your tax liability? Are you interested in an investment that can help you save for retirement and enable you to provide income for your heirs?

In the past, many investors ignored variable annuities because they believed they were "too complicated" to understand. Today, many investors are learning that this just isn’t the case. They are turning to variable annuities because they not only offer a competitive alternative in today’s volatile economic environment, but also provide important features not found in other investments.

It’s easy to understand why variable annuities are a popular investment once you look at the potential benefits they provide to investors. In short, a variable annuity is a financial contract between an investor and an insurance company allowing investors the flexibility to choose among a number of different investment portfolios. Because the investment is part of an insurance contract, variable annuities will not only provide tax advantages but also offer an estate benefit to beneficiaries at the time of death.

There are two basic types of variable annuities: immediate and deferred. Immediate annuities are appropriate for investors who need income at the present time, as income payments begin when you purchase the annuity. With deferred annuities, distributions made after age 59 1/2 allow investors to take maximum advantage of income tax deferral. Withdrawals made prior to this age may be subject to a 10 percent IRS penalty.

Let’s take a closer look at how variable annuities work to meet investors’ needs.

Tax advantages

Under current tax laws, variable annuities are one of the few remaining ways to achieve tax-deferred savings growth. In fact, according to Best’s Review Magazine, variable annuities have "evolved into something like a universal retirement savings product." That’s because they offer many of the tax advantages of a traditional retirement account, without some of the limitations. For example, there are no limits on the amount of money you can contribute to a variable annuity.

Dividends and interest earned within a variable annuity are not taxed until withdrawn, allowing your principal the opportunity to grow faster than a taxable investment. With today’s higher tax rates, this is a significant advantage. Here are two reasons why: first, your principal earns interest and is not currently taxed; second, your interest earns interest and is not currently taxed.

Let’s consider the advantages of tax deferral in more concrete terms: If you’re in the 36 percent tax bracket and invest $10,000 earning an annual rate of 7 percent, your principal would grow to $24,027 over 20 years in a taxable investment. If your investment was tax deferred, however, your money would grow to $38,696 within that same length of time.

Of course, the income you earn in an annuity will be taxed upon withdrawal, but in a deferred annuity that will probably be after retirement, when you’re likely to be in a lower tax bracket. In an immediate annuity, your periodic payments — which are considered to be return of principal plus interest earned on the principal — also receive tax-favored treatment since there are no taxes on the return of principal portion of each payment. Therefore, the money you invest continues to grow tax-deferred until you receive it as part of an income payment.

Investment choices

Most variable annuities allow you to allocate your money among many different investment portfolios, including domestic and global stock, bond and money market funds. Like mutual funds, these portfolios are professionally managed and pool investors’ funds, so risk can be minimized through a level of investment diversification that would be difficult to achieve independently. You can also transfer assets freely among different funds as your personal goals and market conditions change without triggering tax events, such as capital gains.

Something particularly important in today’s low interest rate environment is investment flexibility. Such flexibility within a variable annuity allows you to decide how your money is invested and gives you the opportunity to generate higher returns on your capital. Keep in mind, however, the value of your annuity depends on the actual performance of the underlying investment portfolios. Your return will fluctuate and can be worth more or less than your original investment at any given time.

Flexibility

Variable annuities allow you to choose a payout option that can help you meet the important financial milestones in your life, whether you want to fund your child’s education, build a new career, or supplement your retirement income. Depending on your age and financial situation, you may elect to withdraw your money immediately or at a later date. You can also help design the size and duration of your payouts. For example, you may decide to receive regular payments for a specific time period, regular payments for life, regular payments for life plus the life of a loved one, or specific payments made in equal, periodic installments.

Whatever payout options you choose, it’s important to understand that variable annuities should be considered a long-term investment. While in most cases you can access your money at any time, as most annuities allow a free withdrawal annually of as much as 10 percent, there are often significant surrender charges imposed for early withdrawals. As stated earlier, in the case of deferred annuities, there is a 10 percent tax penalty assessed on withdrawals prior to age 59 1/2.

Estate benefits

To some people, the most attractive feature of an annuity is the ability to pass a lifetime of income on to their beneficiaries. Most variable annuities promise to provide an estate benefit which is at least equal to your principal investment, less any withdrawals, at the time of your death. That means, even if your portfolio performance is down, your heirs will receive no less than what you invested. What’s more, many annuities are now offering a guaranteed minimum estate benefit which will increase annually at a pre-determined rate for a specified period of time.

Variable annuities are sold by prospectus only, which includes more complete information on charges, expenses and risk factors. Variable annuities are long-term investments designed for retirement purposes. Withdrawals may be subject to surrender charges and if taken prior to age 59 1/2, a 10 percent IRS penalty may apply. Variable annuities are not insured by the FDIC.

Talk to your investment executive

If you’re interested in increasing income, minimizing taxes, providing for your heirs, and planning for your important financial obligations, you should find out more about variable annuities. Call your investment executive today. He or she can help you decide whether variable annuities are right for you.

The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information or any opinion expressed constitutes a solicitation for the purchase or sale of any security.

Kevin FitzGerald is first vice president-investments at PaineWebber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 654-6162, ext. 448.