Variable Annuities Part 1 of 4: How They Work – and How They Measure Up to 401(k)s

As the end of 2017 approaches, naturally our minds turn to thoughts of holidays past and present, good times spent with family and friends, the joy of watching our children and grandchildren open presents under the tree, and … taxes.

Wait, TAXES? Okay, maybe that’s a bit of a stretch. But it won’t be long before you’re tackling your 2017 return, as well as thinking about ways to keep Uncle Sam’s hands out of your pocket in the future. So, to get you prepared, we’ve dug deep into our vast database of research and expertise – and produced a four-part guide on a key investment product designed to keep the tax man at bay: Variable Annuities!

Not only that. We’re also going to explain how variable annuities measure up against several other alternatives. This week’s candidate is the 401(k) plan, and it will be followed by others including IRAs, Indexed and Fixed Annuities, and Variable Life and Variable Universal Life Insurance. We trust you’ll find this information valuable now, and down the road – a gift that keeps on giving well past the holidays, if you will.

Now, let’s get started with the basics …

Variable annuities were first introduced by insurance companies back in 1954. The idea was to come up with an alternative to the industry’s existing product offerings which, at the time, were all based on fixed contributions resulting in fixed payouts.

It wasn’t that fixed annuities weren’t popular. But insurance companies couldn’t help noticing the rising popularity of mutual funds. They wanted to compete with mutual funds by offering policyholders the potential for higher earnings. Variable annuities provided the answer. They maintained most of the attractive features of the traditional fixed annuity. Plus, they allowed investors to choose from a range of mutual funds.

How Variable Annuities Work

When you buy a deferred variable annuity, the insurance company invests your money into a mutual fund or collection of funds you designate, recording a corresponding liability to you, the policyholder. Unlike money you invest in a fixed annuity or a whole life insurance policy, variable annuities are managed by an investment company using mutual fund “subaccounts” that are kept totally separate from the insurer’s other assets.

Your funds are therefore not subject to claims by its creditors should the company become insolvent. In that sense, a variable annuity is much safer than a fixed annuity or even a life insurance policy. The risk you take is primarily due to any risk in the mutual fund investments you choose.

From that point forward, all income you earn is tax-deferred. You pay no income taxes on it until you begin making withdrawals at retirement.

Illustration 1: The Power of Tax Deferment

What impact does this have on your tax situation and future earnings? Let’s say you want to make a one-time investment of $20,000 and then see what happens under two scenarios – one utilizing the tax-deferred power of a variable annuity, and another using an ordinary taxable mutual fund where you receive and reinvest an annual distribution of earnings.

For the purposes of this illustration, we’re going to assume you have a marginal tax rate of 25% and you earn an average annual net return of 4% on each investment. However, dividend distributions from the taxable mutual fund are subject to a maximum 15% tax rate for taxpayers earning up to $400,000 ($450,000 for married persons filing jointly) per year. Also, in order to simplify the illustration, we’ll assume there are no sales commissions, loads, or other annual fees for either type of investment vehicle.

You can see the power of tax deferral, particularly over time. Your investment would grow to almost $65,000 under the annuity scenario, versus only around $54,500 with the taxable fund.

Furthermore, if you’re unfortunate enough to suffer an early demise before retirement, the insurance company will pay your designated beneficiary or estate the net balance of your accumulated contributions (less withdrawals) plus any earnings. Unlike a term life or whole life insurance policy where you pay in a small amount to guarantee a large death benefit, the insurance aspect of variable annuities merely guarantees payout of the money that has been invested plus the accumulated gains.

There’s one more built-in cushion: Let’s say you invest most of your money in stock market funds and the market takes a tumble. Plus, let’s say you pass on before retirement and before the market recovers. Your designated beneficiary or estate is guaranteed to receive at least the net amount you paid into the annuity – with no deductions for the decline in the value of your investments.

VAs Vs. 401(k)s: Let’s Get Ready to RUUMMBBLLEEE!

Of course, variable annuities are NOT the only vehicles available to you for use in your retirement planning. So, don’t allow yourself to be swayed by a salesperson’s pitch directing you to one type of investment over another. Instead, decide for yourself what product best suits your needs and then use the salesperson as a resource to help you find the best deal for you.

One major alternative is the iconic 401(k) plan. Such a plan allows you to make an elective pre-tax contribution of up to 100% of your annual salary (with a limit of $18,000 for 2017; savers age 50 or older can add $6,000 to that) into an investment account for retirement. In addition, many employers offer matching contributions up to a certain level as an inducement to participate in the plan. This amounts to free money just for participating, and is over and above the elective employee limits.

Your contributions (and your employer’s matching contributions) will grow tax free. When you withdraw them, however, you will have to pay taxes on the entire amount of the withdrawal.

If you make a withdrawal prior to reaching age 59 1/2, you may also get socked with a 10% penalty from the IRS. Plus, most employers impose an additional restriction on the portion they contribute to your 401(k) plan by subjecting you to a vesting period. If you leave the company before a certain number of years, a portion of these matching contributions will be withheld.

Like variable annuities, most 401(k) plans offer an array of mutual funds to choose from. They also allow you to switch monies from one fund to another at no cost. But since your employer selects the manager for the 401(k) plan, you have no say over the quality of the funds available to you in terms of their performance and costs.

Here are the advantages of a 401(k) plan over a variable annuity …

Advantage #1. Your contributions to a 401(k) plan are before taxes (whereas contributions to a variable annuity are after taxes). Thus, the 401(k) plan gives you a tax break in the current year – a feature which is not available through a variable annuity.

 Advantage #2. Company-matching contributions. Not all 401(k) plans offer this, but you should certainly take advantage of this attractive feature if it is available to you.

 Advantage #3. Most 401(k) plans offer a loan feature, giving you quick access to cash with no pre-qualifying conditions and no IRS penalties. Variable annuities do not offer this type of temporary access to your money.

On the flip side, here are the disadvantages to a 401(k) plan …

Disadvantage #1. The government limits the amount of pre-tax dollars you can contribute to these plans. Therefore, if your retirement goals require investing more than the yearly maximum, you may need to supplement these with other investments.

 Disadvantage #2. Some individual plans may be unattractive compared to variable annuities if they incur extraordinarily high costs or they impose severe restrictions on your ability to get to your funds without first leaving the company. Every plan is different.

 Disadvantage #3. Your investment choices are limited to the funds your employer has selected.

Illustration 2: How a 401(k) Can Save You Big Bucks Over Time

Let’s look at another illustration to help show you how a 401(k) can save you big bucks over time. Assume John Smith is employed by ABC Manufacturing Company, where he is paid an annual salary of $50,000. Then we’ll compare two scenarios: One where he annually contributes 15% of his pre-tax salary to a company-sponsored 401(k) plan; and the other where he takes the same amount, pays taxes on it, and then invests it through a variable annuity.

For the purposes of this example, assume that the net rate of return for each of these two investment vehicles is the same at a conservative 4%, and Mr. Smith is in the 25% marginal tax bracket.

As you can see, your investment will grow much faster when you can fund it with pre-tax dollars through a company-sponsored 401(k) plan. And if your employer offers matching contributions, the results are magnified even further.

Now, let’s assume Mr. Smith has reached retirement and decides to convert his investment from 30 years of savings into an immediate annuity with a fixed 15-year payout.

Based on this conservative example, Mr. Smith would receive $3,585 more per year during retirement by investing through a 401(k) plan than he would by investing through a variable annuity. If you assume a more aggressive 7% annual return, this differential widens to $12,706 per year. These results are magnified even further for individuals in higher tax brackets.

Bottom line: Everyone who has a 401(k) plan option available to them should seriously consider saving for retirement through it. If your company doesn’t offer one, speak with your Human Resources manager and suggest they start a plan immediately. It’s a shame not to take advantage of the tax savings the IRS has made available to you and your company.

As always, be sure to check an insurer’s safety rating on the Weiss Ratings website. And be sure to tune in next week for Part II of this valuable series.

Think Safety,

Gavin Magor