Before You Buy a Variable Annuity…

I got asked the other day what I had against annuities. Let me first explain that my issue has more to do with variable annuities over fixed annuities.  Fixed annuities can serve a legitimate purpose in a retired individual’s portfolio.  (There are options that may be better though). What I do want to address in this entry is:

1) the proper location of one’s investments

2) the tax consequences of investing in a variable annuity.

Too many tax professionals do not have a good sense of the investment side of an individual’s financial life and too many investment professionals do not have a good sense of the tax consequences of the recommendations they make. Have you ever wondered why when you talk to most investment professionals they always lead with the disclaimer that you need to discuss with your tax professional the tax consequences of the recommended investments? Is this a CYA (cover your assets) because they are abnegating a large portion of being the trusted financial adviser you thought they would be?

The above situation really plays itself in the sale of variable annuities. (Yes, I said in the sale of variable annuities!  In my humble opinion, most variable annuities are sold rather than bought. Remember most variable annuities pay your adviser a very sizable commission.) First, I believe in asset location: your interest-earning assets belong in tax-deferred accounts, large company domestic investments belong in non-qualified brokerage accounts and small company and international investments belong in Roth IRAs as much as possible. When a person is sold a variable annuity, the adviser will base their investment recommendations inside the VA off the individual’s risk tolerance. I am not saying you should not make investment recommendations based off of someone’s risk assessment.

What I am saying is you need to be mindful of the tax consequences of a variable annuity. See what must people forget (or are never told) is when you take money out of your annuity it will be taxed at ordinary income tax rates. This could be a real kicker if you are in the 25-35% federal tax bracket (not to mention state income tax). My belief is your asset allocation based off of your risk assessment should be spread out amongst all your assets in their most tax efficient bucket as possible. A variable annuity violates this principle because you are taking assets that could be held inside of potential long-term capital gains account or a Roth IRA and now subjecting them to more tax than need be.

The next time your financial adviser (or insurance agent) tries to sell you a variable annuity ask them the following questions:

  1. Have I maxed out all available retirement plans?
  2. Why can’t I just purchase the same investments outside the annuity “wrapper” and only be taxed capital gains rates?
  3. How much more are you getting paid to recommend a VA to me over a mutual fund account?
  4. What about flat-fee variable annuities?
  5. How much is the mortality expense inside of the annuity you are recommending compared to other variable annuities on the market?
  6. Do you get special recognition or commission to sell one company’s annuity over the other company?
  7. Why are you recommending a variable annuity inside of an IRA? I thought my IRA and/ or variable annuity are already tax-deferred? (This is the big mortal sin of annuity sales!)

If you are recommended by your adviser to purchase a VA, I would stop and get a 2nd or 3rd opinion. The time spent in getting that opinion could save you a lot of money down the road.

About the author

Kevin F. Jacobs, CFP®, EA

Kevin Jacobs, the founder of Step By Step Financial, LLC, has been a recognized CFP® practitioner since 2008 and has been in the financial services industry since 2005. As an Enrolled Agent (EA), Kevin is also licensed to practice before the IRS. Before 2005, he served as a youth director in Memphis, TN. Kevin and his wife, Donella, have seven children (5 boys and 2 girls). They are active at their church and Kevin is also very involved in the community of Broken Arrow.


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