Does Your Variable Annuity Cost Too Much?
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
February 11, 2008
Investors have tucked away more than $1 trillion in variable annuity (VA) products, with a lot of those dollars potentially sitting inside contracts with expenses that may be higher than necessary. The good news for investors seemingly stuck with higher-cost VAs is that they need not suffer from "buyer's remorse," as the Internal Revenue Code (IRC) offers potential income tax relief under section 1035.
IRC section 1035 allows for the "like-kind" exchange of one annuity (fixed or variable, provided annuitization has not begun) or life insurance contract for another, even between different insurance carriers, without any current income taxation. Thus, investors may not necessarily be stuck with high-cost annuities for fear of negative income tax consequences.
The Schwab Center for Financial Research studied the factors surrounding a section 1035 exchange. We looked at the potential benefits of exchanging a higher-cost VA product for a lower-cost, no-load product (assuming equal investment performance), as well as the rules and mechanics surrounding such an exchange.
- In the absence of surrender charges, and all else being equal, investors with higher-cost VAs should consider exchanging to variable annuities with lower costs.
- While the presence of surrender charges could be an obstacle to a cost-effective exchange, the charges in and of themselves shouldn’t necessarily keep you from exchanging to a lower-cost VA. Depending on the size of the surrender charge relative to the anticipated cost savings, and the time interval until the next change in surrender charges, you may still benefit from a 1035 exchange.
Lowering expenses is the primary motivation for many, but there may be several other reasons for considering a 1035 exchange, including performance of underlying investment choices, flexibility of the contract, credit quality of the insurance company issuing the contract, and available features and benefits. Assuming investment options, performance and credit quality are equal or similar under one VA plan vs. another, the three main factors to consider when contemplating an exchange are income taxes, annual expenses, and surrender charges (deferred load/sales charges).
Variable annuities and income taxes
Contributions to VAs (outside of qualified retirement plans) are not tax deductible, but earnings do grow tax deferred until withdrawal. As with qualified employer plans and IRAs, there’s a 10% federal penalty (plus penalty at the state level, if applicable) for withdrawal of earnings from a VA prior to age 59½. Unlike qualified plans and IRAs, however, the minimum required distribution rules at age 70½ don’t apply to variable annuities. Distributions from VAs categorized as earnings are treated as ordinary income for tax purposes, regardless of how the earnings were derived (i.e., interest, dividends or capital appreciation). However, the actual tax treatment of VA distributions may vary based on the type of distribution (surrender vs. annuitization) and the date on which the contract was entered.
In the context of making a 1035 exchange, it's important to take a closer look at taxation of partial and full surrenders of the annuity contract:
Annuities purchased prior to Aug. 14, 1982 operate under the FIFO (first in, first out) rule. A partial surrender under this rule means the withdrawal is treated as having come first from the cost basis in the contract. Once the cost basis is exhausted, the remainder is treated as ordinary income.
For annuities purchased after Aug. 13, 1982, the partial surrender is taxed on a LIFO (last in, first out) basis, meaning the withdrawal is treated as having come first from earnings and is therefore fully taxable up to the point where the cost basis is reached.
In the case of a full surrender, the income tax treatment is straightforward: the cost basis in the contract is received tax free and all earnings are taxed at the ordinary income rate.
Income taxes aren’t an obstacle to investors wishing to exchange annuities when the annuity has declined in value relative to the cost basis in the contract, because the full surrender would be deemed a return of investment (although investors may lose any potential death benefits by transferring an annuity with enhanced death benefit features under such circumstances). Income taxes, however, could present an obstacle to investors wishing to get out of an existing VA contract when the annuity has untaxed earnings. A tax-free exchange under section 1035 removes this potential income tax obstacle.
If the value of your annuity has fallen below the original amount you invested, and you purchased an enhanced death benefit option, you may lose this death benefit if you transfer out of your current annuity. For a simple example, if your original investment was $100,000 and the value is now $90,000, you would lose $10,000 in death benefits by exchanging your contract.
Ongoing variable annuity expenses (aside from surrender charges, discussed later) include mortality and expense risk charges, administrative fees, underlying investment expenses, and fees or charges for other features. These fees can add up quickly and could significantly erode investment performance over time. Ongoing expenses can be as high as 2-3% per year, on top of loads. It's always wise to shop around, comparing products with higher expenses to available no-load, lower-cost options. You may be able to save 1% or more per year without having to incur new loads in the process. How significant is a savings of 1% to 1.5%? The impact can be very significant over time.
For example, say you currently own a variable annuity with total annual expenses of 2.75%. You're able to exchange it for one charging only 1.5% in total annual expenses without incurring any surrender charges, penalty or current income taxation under IRC section 1035, but want to know how much you could save by doing so:
|Hypothetical rate of return||6.0% (both old and new)*|
|Current annual expense||2.75%|
|New annual expense||1.5%|
*Hypothetical rates of return are neither a prediction nor a projection of any investment product.
You can compare variable annuity expenses simply and efficiently using . The Expense Analyzer compares your current annuity with a particular annuity offered by Schwab to show the difference in estimated annual base annuity expenses (mortality and expense risk charges and administrative fees, including any applicable contract maintenance charge).
If you make a withdrawal from some variable annuities within a preset period of time after purchase, you may incur a surrender charge. Typically, the surrender charge is set as a percentage of the amount withdrawn. This rate usually declines gradually over the preset surrender charge period. For example, surrender charges could be as high as 9% in the initial year and may gradually decline to zero over a period of up to 10 years.
When evaluating surrender charges, the decision to make a 1035 exchange will depend on the "break-even" time, based on the current charge, the cut off date for the next change in surrender charges, and the potential savings associated with the new variable annuity contract. Each situation must be evaluated based on the unique set of facts and assumptions to determine whether it’s potentially advantageous to make the 1035 exchange immediately, or to wait.
Your decision to surrender an existing variable annuity in exchange for a new contract must be based on your own unique circumstances, and you should contact your own professional tax advisor prior to taking any action. Once you crunch the numbers, you may find that a section 1035 tax-free exchange can be an easy and practical way to take greater control over your portfolio expenses and, thus, the future performance of your investments.
Charles Schwab & Co. Inc. distributes variable annuities that are issued by insurance companies not affiliated with Schwab. Not all products are available in all states. Variable annuities and certain other annuities are sold by prospectus only. Before purchasing a variable annuity, you should carefully read the prospectus and consider its investment objectives and all risks, charges and expenses associated with the annuity and its investment options. If you’re interested in getting more information on variable annuities or 1035 exchanges, or want a prospectus, call Schwab Insurance Services at 1-888-311-4887 (option 2) or visit www.schwab.com/annuities.
Variable annuities are suitable for long-term goals, such as retirement, and withdrawals of any earnings before age 59½ may be subject to tax penalties. This analysis has considered the applicable provisions of the Internal Revenue Code of 1986, as amended; the regulations thereunder; and judicial and administrative interpretations thereof, which are subject to change or modification, either prospectively or retroactively, by subsequent legislative, regulatory, administrative or judicial decisions.
A variable annuity’s value will fluctuate depending upon the underlying investment; an investor’s units, when redeemed, may be more or less than the original amount invested. Past performance is no guarantee of future results.
The information and content provided herein are general in nature and are for informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The types of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
Examples included within this discussion are provided for illustrative purposes only and are not intended to be reflective of results you should expect to achieve. Data contained herein from third-party providers are considered reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.