5 MIN READ

Debunking the myth that variable annuities may not offer tax benefits compared to other investments.

This is the fifth in a series of articles to help you overcome common objections to variable annuities (VAs). Each month we’ll tackle a common myth and offer facts and information you can share with clients.

A financial advisor compares the cost of a variable annuity to a client's other investment options.

Variable annuities vs. mutual funds

It's true that variable annuities (VAs) don’t offer a stepped-up cost basis when the account holder dies. Mutual fund investments generally do, and it’s a common argument against VAs. But it ignores a few crucial facts about tax management strategies for both the client and their beneficiary(ies).

Mutual fund investors pay taxes on their distributions every year. So while their beneficiaries may benefit from a step-up in cost basis, investors receive no tax protection on their distributions during their lifetime.

The power of tax deferral

VAs are tax-deferred investments. Clients don’t pay taxes on gains on their account until they withdraw money. What they save by deferring taxes is reinvested and can have the potential to earn more through compounding. The hypothetical example below helps illustrate this. It shows two investment scenarios over 20 years. Both investments started the same day with $100,000, and earned a 10% return each year, net of fees. No withdrawals were made from either.

The difference? One investment was taxable, and the other was tax deferred.

$401,694

The earnings of the taxable investment were paid annually at a tax rate of 28%.

The taxable investment would have had to earn approximately 13.9% every year to equal the same account value as the tax-deferred investment.

Taxable investment

$672,750

The tax-deferred account reinvested the money instead, resulting in a higher total. Even if your client chose to withdraw the $672,750 in a lump sum at the end of the 20 years ($160,370 at the 28% tax rate), they’ll still come out ahead.

Tax-deferred investment

Taxable investment

$401,694

The earnings of the taxable investment were paid annually at a tax rate of 28%.

The taxable investment would have had to earn approximately 13.9% every year to equal the same account value as the tax-deferred investment.

Tax-deferred investment

$672,750

Tax-deferred accumulations are subject to ordinary income tax, and if withdrawn prior to age 59½, an additional 10% federal tax penalty.

This illustration is hypothetical and doesn’t represent any particular investment. It can’t be used to predict an expected outcome for your client’s particular situation. And changes in tax rates and tax treatment of investment earnings may impact the comparative results. Clients should consider their personal investment horizon and personal income tax bracket, both current and anticipated, when making an investment decision as these may further impact the results of the comparison.

If fees and charges were included in the illustration above, the tax-deferred performance would have been lower. Lower maximum tax rates on capital gains and dividends would make the investment return for the taxable investment more favorable, thereby reducing the difference in the performance between the accounts shown.

Structuring VAs to relieve taxes on beneficiaries

There are a few ways you can structure VAs for your clients to help relieve the tax burden on their beneficiaries.

First, some VAs offer insurance death benefits that don’t require underwriting (PDF) that passes outside of probate. For someone who wants to leave a financial legacy to their loved ones, this can be a good late-in-life option.
Second, if VAs are established with nonqualified money, beneficiaries can use a stretch option (PDF) that allows them to spread income distributions over their life expectancy. (Even qualified money can be stretched as much as ten years.) Stretch options help alleviate the immediate tax burden caused by a lump-sum distribution.

Here's how that could work.*

First, second and third generation variable annuities.

*For this example, we assume funds grow at an annual rate of 8%. First owner doesn’t make additional contributions and no adjustments are made for inflation, which could erode the purchasing power of the investment. We also assume the first owner doesn’t need assets in the account before or during retirement—so no withdrawals are taken while owning the annuity.

All assumptions are hypothetical and for illustration purposes only. We’re assuming an investment-focused variable annuity is being used for the stretch. Investments would be subject to market risk and the end balance may be higher or lower than what we’ve shown. As always, individual results will vary.

VAs purchased by a grantor trust (PDF), allow a trust-owned annuity to create a multi-generational financial legacy that spreads income—and the associated tax burden—over time.

Bottom line: VAs offer another option for tax-deferred investing and are best suited for long-term investing for clients. Since the money’s invested in the market, there are risks involved, including the potential loss of premium(s). But because a VA offers tax-deferral and compounding, it could potentially result in higher long-term returns.

A shopper is shown with her many retail purchases; she likewise should have many options when choosing investments.

Debunking the myth that variable annuities limit investment options

Want to learn more?

Low cost VA (PDF)

Learn more about variable annuities from Principal.

Contact your local Principal^® representative or support team at 866-309-1623.

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You can create an investment plan for clients now, and for their future, all within one product. Learn more about VAs at principal.com. To get started, contact your local Principal^® representative or support team. Call us at 866-309-1623.

Investing in taxable or tax-deferred vehicles involves risk, and you may incur a profit or loss in either type of account. Changes in tax rates and tax treatment of investment earnings may also impact comparative results. Investors should consider their personal investment horizon and income tax bracket, both current and anticipated, when making an investment decision, as these may further impact the comparison.

The subject matter in this communication is provided with the understanding that Principal^® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Withdrawals prior to age 59 1/2 are subject to a 10% IRS penalty tax. Tax-qualified retirement arrangements, such as IRAs, SEPs, and SIMPLEIRAs are tax-deferred. You derive no additional benefit from the tax deferral feature of the annuity. Consequently, an annuity should be used to fund an IRA, or other tax-qualified retirement arrangement, to benefit from the annuity’s features other than tax deferral. These features may include guaranteed lifetime income, death benefits without surrender charges, guaranteed caps on fees, and the ability to transfer among investment options without sales or withdrawal charges.

Annuity products and services are offered through Principal Life Insurance Company. Securities offered through Principal Securities, Inc., member SIPC, and/or independent broker/dealers. Referenced companies are members of the Principal Financial Group^®, Des Moines, IA 50392.

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This information is educational only and provided with the understanding that Principal^® is not rendering consulting, legal, accounting, investment or tax advice. You should consult with appropriate individuals including counsel, financial professional or other advisors on all matters pertaining to business, legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services provided through Principal Life Insurance Co., a member of the Principal Financial Group^®, Des Moines, IA 50392.