Variable Annuity Disadvantages

Overview

Variable annuities are designed for retirement investment. And, although they feature many benefits over mutual funds and fixed-interest instruments, variable annuities are not ideal for everyone. Beware of the following disadvantages:

  • 10% IRS Penalty — Income withdrawals before the age of 59.5 are charged a 10% tax penalty by the IRS.
  • Not Considered a Capital Gain — Growth is tax-deferred, but eventually income is taxed an ordinary income tax rates, not capital gains.
  • Potential Loss of Capital — Unlike fixed-rate instruments, variable annuities can depreciate in value.
  • Withdrawal Charges — The insurance company usually imposes a penalty if withdrawing over the yearly allotment.
  • Management Fee — The entire account incurs a 1-3% management fee every year, like a mutual fund.
  • Annual Contract Fee — A $25-35 annual charge paid to the insurance company to cover administrative expenses.

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The IRS Annuity Penalty

Income withdrawn from a variable annuity before the age of 59.5 is subject to a 10% IRS tax penalty. This fee is designed to encourage investors to treat variable annuities as long-term retirement saving instruments. 401(k)s feature a similar penalty for the same reason. 10% is a substantial enough reduction to discourage younger investors who may not be looking for a retirement income quite yet. These investors are better off with a mutual fund or a traditional brokerage account. Retirees needn't worry about this potential disadvantage.

Variable Annuity Taxation

Even though variable annuity income isn't taxed immediately, at some point it will be taxed, and when that time comes it will be taxed at ordinary income rates. Unlike stock market gains, variable annuity income isn't considered capital gains. The disadvantage of this is proportional to the difference between your ordinary income tax bracket and the current capital gains tax rate.

An investor in a 33% ordinary tax bracket would pay 17% less on a stock investment taxed at the current capital gains rate of 15% than on variable annuity withdrawals. With such as savings, you might wonder why anyone would invest in anything but stocks. However, direct stock market investment is risky, and not appropriate for many retirement plans.

Comparing apples to apples, the capital gains exempt status of variable annuities isn't a huge disadvantage. Money market accounts, mutual funds, 401(k)s, and bonds are all capital gains exempt. And when compared to its neighbours, a variable annuity actually offers one of the best tax advantages — deferred payment — while others are taxed on a yearly basis.

Capital Loss Potential of Variable Annuities

When it comes to investing, greater growth almost always comes at the cost of risk, and variable annuities are no exception. Unlike a fixed annuity, CD, or money market account, variable annuities can lose capital. Your initial deposit is invested in equities, which can depreciate and come to be worth less than when initially purchased. In such cases, part of the initial investment can be lost.

Consider variable annuities in terms of other equity instruments. Brokerage accounts, mutual funds, and 401(k)s all share the potential of capital loss. Over the long-term, however, when properly diversified and allocated, they yield higher returns. In this light variable annuities are suitable for retirement savings, but they shouldn't be an exclusive part; be sure to hedge equity risk with fixed-rate instruments.

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Withdrawal Charges

The withdrawal charge is a disadvantage of all variable annuities. These charges are designed to limit withdraws because it's in the insurer's interest to keep your money invested for longer durations. A charge of up to 10% can be levied on any withdraws over the contract's allowance limits. The allowance limit is how much you can withdraw per year before incurring charges.

Typical allowances range from 5-15%. This means that had you invested $50,000 in a variable annuity, you'd have penalty-free access to approximately $10,000 every year. Withdrawing past this limit is possible, but additional fees would be incurred.

Withdrawal charges are a disadvantage of most annuity-related instruments. Mutual funds, CDs, and even treasures feature stiff penalties for early withdraw. The penalty-free withdraw limits actually make variable annuities uniquely flexible because, in contrast to CDs, you can at least cash out some of the money without a substantial income reduction. If you're worried about withdrawal fees, consider a brokerage or money market account. They're both viable alternatives, but their flexibility is counterbalanced by excessive risk and low rates, respectively.

Variable Annuity Management Fees

Variable annuity portfolios assess a management fee on the entire account balance every year. This fee ranges from 1-4%, the same as for mutual funds. Half of this fee pays the insurance company's overhead while the other half goes to the brokerage house managing your portfolio. Management fees are the most significant reason to choose a 401(k) or stock investment over a variable annuity.

Although management fees can eat away as much as 4% of growth per year, variable annuities compensate with high long-term performance. Compared to a fixed annuity or CD, which averages 5-7%, a variable annuity averages 10-12%. Even with a high management of 3%, the variable annuity comes out on top. And while it's true that a stock market investment averages 12-14% without management fees, direct equity investment is too volatile to comprise a substantial portion of most retirement plans.

Annual Contract Fee

To help cover paperwork and administration costs, insurance companies like to assess a $20-$40 annual contract fee on variable annuities. This fee is miniscule compared to other investment costs because it's fixed and not percentage based. Every year your account will be debited $20-40 regardless of balance or performance. The annual contract fee is something to be aware of, but it is not a significant disadvantage.

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