Tax-Deferred Cocktail: Mixing IRAs With Variable Annuities

It sounds redundant: Put a tax-deferred investment, like a variable annuity, inside an already tax-deferred IRA or retirement account? But the wisdom of such a move is actually subject to much debate.

In fact, fifty five percent of all variable annuity assets are in IRA rollovers and qualified retirement accounts, such as 401(k) s, 403(b) s and Keogh accounts, according to the National Association of Variable Annuities (NAVA), Reston, Va.

Financial advisors often recommend that clients put annuities in qualified plans or IRAs primarily for their insurance benefits and income guarantees, according to a 2006 NAVA study. Seventy percent of the 1,000 advisors polled cited the variable annuity death benefit—a guarantee that when the policyholder dies, the beneficiary receives the greater of the market value or original principal--as one of three top reasons for advocating using variable annuities inside qualified plans or IRAs. Sixty-six percent named guaranteed lifetime income, and 61 percent listed living benefits.

The majority of respondents also reported that they favored variable annuities in IRA rollovers as a way to manage client investments in a large number of funds from a large number of mutual fund families.

Another top reason: The Guaranteed Lifetime Minimum Withdrawal Benefit. With this common feature, the annuitant is promised, at minimum, a return of all contributions—regardless of how the underlying investments perform. This guarantee can come in the form of regular withdrawals paid over a specific period. The most popular type promises withdrawal rates of at least 5 percent annually for life starting at age 65. Many insurers step up the withdrawal rate annually if the annuity is held for at least 10 years.

Hard on the Pocketbook
But is it appropriate to put an already tax-deferred retirement account inside another tax-deferred instrument? Many financial advisors believe it does not make sense. Investors, they say, can do a better job diversifying IRAs or 401(k)s to get high risk-adjusted rates of return, as well as income over the long-term. Their other big beef: The high cost of variable annuity insurance and fund management fees reduces the client’s return on tax-deferred investments.

Jeffrey D. Voudrie, financial planner and president of the Legacy Planning Group, Johnson City, Tenn., says one of the main arguments for using a variable annuity inside an IRA is flawed due to the high cost.

Most variable annuities sold through commission-based advisors have mortality and expense charges of 1.45 percent. This is an annual fee that is charged against the entire value of the account--not the original investment. On a $500,000 investment, that can amount to $7,250 the first year. If the value of an account doubles in 10 years, the cost would rise to $14,500 that year, he says.

There are also mutual fund management fees, ranging from 70 basis points to 1.5 percent. Plus optional living benefit riders cost more than 60 basis points annually. As a result, the average variable annuity charges range from 200 to 300 basis points annually.

“That’s $10,000-$15,000 each year on a $500,000 investment—and that expense increases as the value of the account increases,” Voudrie argues. “Do you really think it costs $10,000-$15,000 a year to cover the cost of the insurance associated with (for example, the death benefit)? Of course not.”

Fee-only financial planners, like Jane King, president of Fairfield Financial Services, Wellesley, Mass., prefer to invest IRA rollovers in no-load, low-cost mutual funds. King diversifies in growth and value stock funds, international funds, bonds and money funds for attractive risk-adjusted rates of return. Her retired clients use up their non-retirement savings assets first, leaving the retirement account to grow in value--even while taking the minimum required distributions. As a result, the tax-deferred IRA can be left to a child as an inherited IRA. The child can then take distributions based on his or her life expectancy.

A report by the New York law firm, Milberg LLP, says the insurance features of the variable annuity are not likely to justify sales of the product, because the insurance tends to be actuarially worth only a fraction of the higher fees. Those high fees, the report suggests, go toward profit and high sales commissions.

Cost Comparisons
However, John Huggard, estate planning attorney and author of “The Truth About Variable Annuities--Debunking The Myths,” Parker-Thompson Publishing, disagrees.

The biggest flaw in the high-cost argument is the incorrect assumption that variable annuities are more expensive to own than other qualified investments, such as mutual funds, he contends.

For example, the average cost of owning a variable annuity in a qualified plan is about 2.9 percent. This includes fees paid to money managers, commissions, trading costs and insurance costs. But the average annual cost of owning an A-share mutual fund held in a qualified retirement account is about 3.23 percent.

“The average stock mutual fund held in a qualified retirement account is 33 basis points more expensive to own on an annual basis than a similar variable annuity held in a qualified retirement account,” says Huggard.

Huggard refutes those who argue that the practice of placing a variable annuity inside a qualified plan or rollover IRA results has no benefit because it duplicates the benefit of income tax deferral. “The duplication argument would have validity only where a variable annuity offered some income tax deferral as its sole benefit,” he said.

However, Huggard stresses that people put a variable annuity inside a tax-deferred IRA or 401 (k) to get insurance coverage. They are willing to pay the annual fees and charges to protect principal.

Those guarantees include:

• The guaranteed death benefit.
• Guaranteed minimum withdrawal benefits.
• Guaranteed minimum income benefits: With these, an annuitant can receive a guaranteed dollar amount in monthly income--regardless of how the contract's investments perform.