In response to Darrow’s recent post on inheriting an annuity, I received the following comment, which I edited for clarity:
I have a variable annuity via Fidelity. It is the result of a 1035 conversion of a whole life insurance product I wish I hadn’t bought in my late 30’s…..I pay .1% (for a) Fidelity VIP Index plus .25% annual annuity charge for a total of .35%…..For comparison FXAIX (Fidelity’s S&P 500 index) charges .015% or .335% less than the annuity version. Thus it is $335 more expensive per year per $100,000 invested.
The variable annuity is better than the whole life product! I’m glad I was able to turn lemons into lemonade.
Would I buy it again on its own merits? Yes!….I’m sure I’m missing something because everyone else is so negative on them.
This comment highlights an excellent strategy for those who have been sold annuity and insurance products they regret buying, the 1035 exchange. On a less positive note, the idea of buying an annuity on its own merits highlights the misunderstanding of annuity fees and taxation that I suspect are the reason so many people end up with these products that they later regret. Let’s explore….
Let’s start with the part of this comment that I love, the 1035 exchange. Section 1035 is a section of the IRS code that allows a tax-free exchange of one insurance contract for another.
Section 1035 applies to life insurance, endowments, and qualified long-term care insurance (LTC) policies, as well as annuities. I learned the mnemonic device below that helped me when preparing for my CFP exam:
Any of these policies can be exchanged for a like kind of policy. Life insurance policies, at the top of the pyramid, can be exchanged into another life insurance policy or for any of the other policy types below it on the pyramid. At the other extreme, LTC policies, at the base of the pyramid, can not be exchanged for anything other than another LTC policy.
Annuities, being near the bottom of the pyramid, are a popular place to exchange undesirable, but commonly sold, life insurance products or annuities. As such, there are products sometimes termed “rescue annuities” because they are designed for the purpose of rescuing consumers from suboptimal products they were sold.
Vanguard used to offer a product for this which I exchanged my parents’ annuities into years ago. They no longer offer these products. To my knowledge, the Fidelity annuity product referenced in the comment is the best option currently available.
When to Consider a 1035 Exchange
1035 exchanges work best with an insurance contract that you were sold years or decades ago outside of a qualified account. In this scenario, you are typically out of any surrender period that would prevent you from exiting the contract.
However, you may have accumulated substantial taxable gains. These gains would make surrendering the contract in one lump sum undesirable due to tax consequences.
A 1035 exchange to a more favorable contract provides a reasonable solution. You can lower your fees. You will also buy time to continue deferring taxation and to determine a more tax efficient strategy to get money out of the annuity rather than taking a lump sum all in one year.
Choosing an Annuity?
A 1035 exchange can be a good solution to “make lemons out of lemonade” with an old annuity or life insurance product you were sold. But do these low-cost annuities deserve to be considered on their own merits? Generally, no.
There are two key reasons for this: annuity fees and taxation of annuities.
Let’s take a closer look at the fees on the annuity mentioned. It is one of the lowest fee variable annuity products on the market, if not the lowest.
The commenter astutely points this out, noting the difference of .35% all-in for the variable annuity vs. .015% for the same investment purchased outside of the annuity. The commenter also correctly points out that the difference of .335% equates to a difference of $335 per year on a $100,000 investment.
However, this overlooks (I believe accidentally) the same thing that those that sell these contracts don’t explain (I’m not as generous in assuming it is accidental on their parts). That overlooked component is the compounding of fees!
Let’s consider the difference between two otherwise identical $100,000 investments. Each compound at 8% per year minus their respective fees for twenty years.
A $335 annual fee for twenty years would be $6,700. But fees aren’t linear. They compound. Determining the actual impact of this fee difference requires a couple of time value of money calculations.
The money invested in the variable annuity with all in fees of .35% would compound to $436,798. This same amount of money invested with all in fees of .015% would compound to $464,803.
The result of this seemingly small difference in fees results in ending with $28,005 less after the twenty year period, all else being equal. If we compound the difference out 30 years, the difference grows to $89,186!
Anyone selling annuities will be quick to point out that this is not a valid apples to apples comparison. Annuities are taxed differently than taxable investments.
This is true! However, in most cases taxation is another reason to avoid annuities rather than a reason to choose them.
Taxation of Annuities
Investment gains in an annuity are shielded from annual taxation. This is the biggest tax advantage provided by an annuity.
In exchange for this benefit, gains on investments inside the annuity lose favorable capital gains tax treatment. Any gains within an annuity are ultimately taxed as ordinary income when a withdrawal is taken, similar to a non-deductible IRA. Also similar to a retirement account, annuity withdrawals are subject to a 10% penalty on the gains if taken before age 59 ½.
In addition, annuity withdrawals are taxed on a last-in, first-out basis. This means that 100% of every dollar you take from an annuity is taxed as ordinary income (and subject to early withdrawal penalties) until all of the gains are exhausted. At that point, the remainder is a tax-free return of your principal.
If you elect to annuitize payments, taxation is a more complicated formulation where each payment consists partially of taxable gain and partially tax-free return of principal for your calculated life expectancy. If you outlive your life expectancy, payments become 100% taxable as ordinary income.
Annuities vs. Other Tax-Advantaged Accounts
Annuity gains are taxed as ordinary income like a tax-deferred retirement account. Annuities come with early withdrawal penalties similar to qualified retirement accounts. They don’t come with the upfront tax deductions of traditional retirement accounts or tax-free withdrawals of Roth accounts.
Therefore, there is little reason to ever consider buying an annuity if you are not first maxing out all other tax-advantaged options (work sponsored plans, IRAs, HSAs, etc.). They provide superior tax benefits, less complexity, and generally lower fees.
There is also no reason to ever buy an annuity inside of a qualified account for tax benefits. The tax benefits of the retirement account are already superior to those of an annuity.
If you are a super saver who maxes out all your tax-advantaged accounts, annuities can provide some additional tax advantaged space to shield your investments from the annual tax drag created by taxation of income produced within a taxable account. However, the value of this tax benefit comes with trade-offs that make this benefit questionable at best.
Annuities vs. Taxable Accounts
How beneficial is using an annuity to eliminate annual tax drag? The value is dependent on several factors.
The first is what you plan to invest in. If you are following the first rule of thumb of utilizing all your available tax-advantaged accounts, they will provide space to hold your least tax-efficient investments. You could use a taxable account to hold only tax-efficient investments like an S&P 500 index fund as mentioned in the comment.
In this case, most of your gains will come in the form of capital gains. Thus you have tax-deferral on the largest portion of your investment gain until you sell the investment. More importantly, you get this benefit free of charge and without the complexity of annuity contracts!
Tax-efficient investments like broad based index funds generate little to no annual capital gains or non-qualified dividends. That by definition is why they are tax-efficient. This leaves you with only qualified dividends which are taxed at favorable rates of 0%, 15%, or 20%.
The second factor when determining the tax benefit of an annuity vs. a taxable account is your personal tax rate and how it will change over time. If you are saving aggressively towards early or semi-retirement, you may very well pay 0% tax on taxable accounts in your lower income years.
Before considering an annuity for tax benefits, make sure you understand the trade-offs this entails. You’ll be giving up favorable tax rates, possibly 0%, on long-term capital gains and qualified dividends in a taxable account to ultimately pay ordinary income rates on any annuity gains. You also have to weigh the negative impact of annuity fees vs. any potential tax benefits the annuity provides.
Should You Buy an Annuity on Its Own Merits?
Few people buy complex annuities like variable or equity indexed products. Most often these contracts are sold by agents who are paid handsomely to do so.
These salespeople play on fears to highlight features like “market-like growth” with limited downside and tax sheltered investment income. They downplay or outright omit discussing the impact of high annuity fees. They misrepresent the fact that in many cases there is no actual tax benefit. In fact, you may pay more tax by utilizing an annuity!
Like this commenter you may find yourself in possession of one of these contracts. You would not make an informed decision to buy this product today. In that case, utilizing a 1035 exchange is a viable option to start fresh in a more favorable contract and allow for future tax planning.
However, there is rarely a reason to buy even the lowest cost versions of these products on their own merits.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to firstname.lastname@example.org. Financial planning inquiries can be sent to email@example.com]
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