A variable annuity is a financial agreement between an insurance company and the annuitant where the insurer agrees to pay a fixed minimum amount of money at regular intervals to the contracted recipient. When you buy a variable annuity, you give either periodic payments or a single lump sum over time. The cash you pay is invested in bonds, stocks or any other investment vehicle you choose. Variable annuities are different from other investments since the periodic, tax-deferred payments are designed for the life of the insured. Usually, they have a death benefit and lack maximum contribution limits. In the face of these advantages, variable annuities have numerous drawbacks that can eat into their benefits.
Variable annuities have a tax-deferral benefit, which can however be problematic. Though profits are not taxed until the cash is removed, variable annuities are still affected by regular income tax rates. In other investments, capital gains tax rates are normally charged. The rate tends to be lower than regular income tax rates. Variable annuities can be beneficial to investors who are in a low income tax bracket. However, the deferred taxes can be quite high for several investors. This makes them less beneficial to the policyholder. Mostly, it can take many years for these annuities to be more tax-efficient compared to the traditional mutual fund. In addition, some states impose additional taxes on these investment options.
High Administrative Costs
The administrative costs can be expensive since variable annuities are, as a rule, sold on commission. This implies that investors might have to pay a big percentage of commission to own the investment. Due to high sales commissions, agents are keen to sell the products. However, to finance these high commissions, consumers pay elevated administrative fees to purchase the annuities. In addition, variable annuities frequently have annual administrative and contract fees. Their fees are high compared to other kinds of retirement investments like regular mutual funds. Usually, each extra benefit — such as a guaranteed minimum income or enhanced death benefit — has a fee attached to it. The fees reduce the return on your investment. A variable annuity also protects your money from inflation though it is not done automatically. You will need to purchase an extra rider that raises your payment during inflation. However, this will in turn increase your costs.
Surrender Penalties and Charges
Variable annuities need policy owners to keep their invested money for long periods to avoid high penalties. Since these annuities are designed for long-term investments, early withdrawal penalties are often charged when cash is removed ahead of the period specified in the contract. In addition to the “surrender charges”, risk and mortality expense charge is added to the account by the insurance companies. This charge usually compensates the company for risks incurred under the contract. Generally, a surrender charge is similar to an early termination fee. In case the investor withdraws the cash before maturity, he may have to give five to 10 percent in fees to end the contract.
High Risks and Lower Returns
Since a variable annuity has insurance features, it takes longer to generate benefits compared to alternative retirement investments. More risk is also associated with a variable annuity. If the investments you select for your annuity drop in value, your annuity worth will also drop. This means that you will get a lower payout and returns.
Lack of “Step Up” in Heirs Cost Basis
“Basis” generally describes the amount of money paid by an investor for the investment. On the other hand, a “step up” basis implies that if the investment is transferred or inherited, the individual obtaining it has a basis in the present value of the investment and not the original cost. For instance, if an investor paid up $10 for the variable annuity but passes on and leaves it to an heir, then the basis remains at $10. In case, the new possessor sells the annuity, then he will have to report the income earned based on original basis. If $10 was the original cost and $100 is the valued annuity, then the new possessor will realize a profit of $90. Had the annuity added a step-up in basis, the present value ($100) would be the new basis, not the original price ($10). This makes a variable annuity a poor alternative for estate-planning purposes. Avoid sticking your successors with tax liability.
Payments Taxed as Ordinary Income
The profits from annuity disbursements need to be reported on a taxpayer’s tax return as ordinary income. This is different from other investments — such as mutual funds — that can be tax-deferred and are not taxed as normal income. Normally, the ordinary income in a variable annuity is taxed at an advanced rate compared to other forms of income. Therefore, the tax consequence of this annuity makes it less lucrative.