Exploiting the VA Tax Edge: An expert offers 12 reasons why variable annuities trump mutual funds on taxes.
John P. Huggard

06/01/2001
On Wall Street
Copyright (c) 2001 Thomson Financial, Inc. All Rights Reserved.

If your clients have additional funds available to set aside for retirement after fully funding their 401(k), IRA and similar retirement accounts, should they invest in a mutual fund or a variable annuity? Since our current income tax laws favor variable annuities over mutual funds, advisors can help clients reach their retirement goals and reduce income taxes by recommending variable annuities. Let me clear up 12 common misconceptions about the tax treatment of these two vehicles.

1

Long-term fund ownership does not guarantee 20 percent capital gains treatment.

One of the myths of investing is that long-term ownership of mutual funds results in a maximum capital gains tax of 20 percent, while withdrawals from variable annuities are subject to ordinary income tax rates of 28 percent and more. But that assumption is flawed. The 20 percent rate is tied to how long the mutual fund company holds its underlying investments, not how long a mutual fund owner holds his or her fund.

The frequency with which a mutual fund buys and sells investments is referred to as its turnover ratio.

A turnover ratio of less than 100 means that a fund, on average, takes more than a year to completely turn over its entire portfolio. It's a fund's turnover ratio - not how long an investor holds his fund - that determines the rate at which the investor will pay income taxes on realized gains.

Another misunderstanding is assuming that a turnover ratio of less than 100 means that all a fund's investments are held for at least a year. This isn't true, either. A turnover ratio of 100 signifies nothing more than, on average, a mutual fund company sells and replaces its whole portfolio once a year. This means that some investments may have been held for less than a year and others for more than a year. Simply stated, a low turnover ratio may not provide mutual fund owners with protection from having to pay ordinary income taxes on a portion of their funds' realized gains.

Currently, equity funds have an average turnover ratio of 107. The typical mutual fund distributes half its realized gains as long-term capital gains and half - in the form of dividends and short-term gains - as ordinary income. This indicates that a substantial portion of a mutual fund's realized gains may be treated as short-term capital gains and dividends, which would be taxed to the owners of such mutual funds as ordinary income.

Example

Assume Andy and Betty are 25 and in the same income tax bracket. Andy buys $3,000 worth of a mutual fund each year that has an average turnover ratio and distributes its realized gains as discussed above. Betty buys $3,000 worth of the same mutual fund each year through a variable annuity. Both investments increase at the rate of 15 percent a year. Who has the tax advantage? Betty.

Andy will pay some income taxes each year on his fund's realized gains based on the fund's turnover ratio. Betty will be able to defer all income taxes until she withdraws money from her variable annuity, which may not be for many years. The negative impact of Andy's income tax burden can be seen when the total value of these two hypothetical accounts is calculated over a typical holding period. For example, by applying a 30 percent average federal income tax, Andy's mutual fund holdings will be taxed at 25 percent (half at the 20 percent, long-term capital gains rate and half at the 30 percent ordinary income rate).

In 25 years, Andy's mutual funds will be worth $397,000. Betty's variable annuity, because of tax deferral, will grow to approximately $734,000 during the same period.

But what about the arguments that variable annuities have higher costs? OK, assume that in the above example the additional cost of owning a variable annuity would reduce Betty's rate of return to 14 percent. In that case, Betty's variable annuity would still contain $622,000 after 25 years, while Andy's mutual fund account would contain only $397,000. Even after Betty's $622,000 annuity is reduced by 30 percent for income taxes, she will still have $435,400, or $38,400 more than Andy.

2

Mutual funds expose investors to hidden income tax expenses and other costly tax traps.

Mutual funds have hidden tax costs that variable annuities do not. For example, mutual fund distributions may cause taxpayers to lose certain income tax credits, exemptions or deductions. When this occurs, these hidden income tax costs must be added to the cost of owning a mutual fund, making mutual fund ownership much less attractive.

Examples

Jim and Deb are both 44 and have four children. He's a law professor; she's a stay-at-home mom. Through inheritance and investing, the couple have investments of $400,000, all held in the XYZ Aggressive Mutual Fund. Based on an adjusted gross income of $128,950 from Jim's teaching, the couple determines they are entitled to the following:

Itemized deductions of $29,000;

Personal exemptions of $16,800 ($2800 x 6);

Medical expenses deduction of $3,328.75 (for $13,000 in medical bills);

Casualty loss deduction of $3,605 (for a $16,500 casualty loss).

In January, Jim received a 1099-DIV from XYZ Aggressive Mutual Fund showing an $80,000 distribution, half from long-term capital gains and half in short-term gains and dividends. This distribution caused Jim and Deb's adjusted gross income to increase from $128,950 to $208,950. When they talked with their CPA, they learned that as a result of the fund distribution they would:

Lose $2,400 of their itemized deductions;

Lose $2,352 in personal exemptions;

Lose their medical expense deduction in the amount of $3,328.75; and

Lose all their casualty deduction of $3,605.

Without the distribution, Jim and Deb would have had taxable income of $76,216.25, and paid a tax of $15,643. With the distribution, taxable income rises to $167,902, on which $38,770.62 in taxes would be owed - or an additional tax of $23,127.62. This is far more than 28 percent.

Another problem arises when a mutual fund owner has a paper loss but receives a distribution requiring him to pay income taxes on a losing fund - the so-called imbedded gain problem. What many fund owners don't realize is that the imbedded gain problem can routinely result in an income tax on fund distributions that hits triple digits!

In January of 2000, Barb followed her financial advisor's suggestion and invested a recent inheritance of $250,000 in a portfolio of mutual funds. By year's end, the portfolio showed a paper loss of $50,000 or 20 percent. Shortly after that, Barb received a distribution based on imbedded gains. The distribution required Barb to pay $10,000 in income taxes. Barb's advisor consoled her by telling her that things would even out when the market moved up again. In 2001, the stock market gained and Barb's fund moved up by $60,000, erasing all paper losses and giving her a paper gain of $10,000. Late in 2001, Barb received a distribution requiring her to send another $10,000 to the IRS. Barb sold her fund shortly after that. She felt lucky to have made a $10,000 profit. What Barb never realized was that an income tax of $20,000 paid over two years on a $10,000 gain is a 200 percent income tax!

3

Variable annuity owners in a 28 percent marginal tax bracket rarely pay 28 percent on VA withdrawals.

Let's not forget that the 28 percent income tax rate on VAs so frequently quoted by fund advocates is a marginal tax bracket. Much of the taxable income of taxpayers in that bracket is taxed at rates as low as 15 percent. What this means, for example, is that married taxpayers who have gross retirement income of as much as $85,000 will pay a maximum of 20 percent in total income taxes even though they are in a 28 percent tax marginal bracket. This is true even if much or all of this income comes from annuity withdrawals.

Example

For the year 2000, John and Mary Smith, both 65 and retired, have a combined gross income of $85,000. Their only deductions are a standard deduction of $9,050 and combined personal exemptions in the amount of $5,600, reducing their gross income to a taxable income of $70,350. That puts them in the 28 percent marginal tax bracket. Of their retirement income, $55,000 is a fully taxable withdrawal from a variable annuity purchased by John years ago. All of their income is ordinary income. The Smith's tax burden on their taxable income would be calculated as follows:

15 percent tax on the first $43,850 =$ 6,577.50

28 percent tax on the next $26,500= $ 7,420.00

Total tax=$13,997.50

A tax of $13,997.50 on a taxable income of $70,350 results in a maximum average income tax of just under 20 percent. This demonstrates that married investors in a 28 percent marginal tax bracket who expect to have gross incomes of up to $85,000 during retirement will pay a maximum average income tax of less than 20 percent regardless of how much of their retirement income is derived from variable annuity withdrawals. It is important to point out to clients that the amount of taxable income taxpayers can have and not be subject to an average income tax exceeding 20 percent has consistently been increased by Congress over the years, and the increases should continue into the future.

If VA owners elect to annuitize, their tax burden will drop further because a portion of each annuitized payment will be treated as a return of principal and won't be subject to income taxation. For example, if a variable annuity owner receives an annuitized payment of $60,000 of which half is taxed at an average tax of 20 percent and half is untaxed because it is a return of capital, the average income tax on the $60,000 stream would be 10 percent!

For a VA owner in a 40 percent income tax bracket, annuitization will reduce the income tax burden on a stream of income to 20 percent based on similar facts.

The National Association of Variable Annuities (NAVA) and two other insurance lobbying groups have proposed to Congress that long-term capital gains rates of 20 percent be afforded owners of non-qualified variable annuities if they annuitize to obtain a lifetime stream of income. If passed, many variable annuity owners will see the income tax burden on their annuity income streams drop to single digits.

4

Paying income taxes annually on mutual fund holdings does not guarantee a tax-advantaged retirement.

Mutual fund proponents imply a future tax reward for mutual fund owners who endure annual income taxation in the present. This rarely is the case.

Assume that Tom and Sally are 60-year-old twins who each made an investment of $1,500 a year for the last 25 years. Tom invested his money in mutual funds returning 12 percent, and paid 20 percent capital gains taxes each year on the growth. Sally invested in a variable annuity and deferred all income taxes. Because of additional costs, Sally's return on her annuity was only 11 percent. Today, Tom's account is worth $152,300, Sally's $190,500.

Assume both twins must now draw income from their accounts. If Tom transfers his mutual fund to, say, conservative corporate bonds, his income will be subject to ordinary income taxes. If the corporate bonds yield 10 percent and Tom pays 20 percent in income taxes, his net annual income will be $12,184 from bonds. He would not be much better off if he decided to keep his mutual fund portfolio intact during retirement. An annual distribution of $15,230 (10 percent) from his mutual fund will yield after-tax retirement income of $12,184, assuming a 20 percent income tax rate.

While Sally also will have to pay ordinary income taxes on her annuity withdrawals, she will have a larger retirement income because her annuity value is $190,500. If Sally withdraws 10 percent of her annuity each year and pays 20 percent in income taxes on this withdrawal, Sally will have an annual retirement income of $15,240.

Once clients realize that paying income taxes on a mutual fund portfolio each year does not provide them with any real tax advantage in retirement, they may well wonder why they didn't defer it through a VA and increase their retirement nest egg.

5

Time quickly erodes any penalty advantage that favors mutual funds.

Proponents of mutual funds make the point that, in addition to expenses charged by annuity companies, both the IRS and the issuing insurer may impose penalties or surrender charges if money is withdrawn from a variable annuity earlier than allowed by the IRS or the issuing company. Generally, the IRS imposes a 10 percent penalty on the growth in a variable annuity if withdrawals are made prior to age 59-1/2. Issuing companies impose declining surrender charges of 7 percent to 10 percent if money is taken out of a VA within the first five to seven years.

Although there are many ways to avoid both the 10 percent penalty and surrender charges, resorting to these avoidance measures is usually unnecessary. Depending on rates of return, investment costs, holding periods and tax rates, it's only a matter of time before the tax deferral advantage of variable annuity ownership overcomes any perceived expense or tax advantage of owning mutual funds. As a general rule, once an annuity has been held for a certain period it can be liquidated and the owner will net more than an investor who purchased similar investments outside of an annuity.

6

Switching from one fund to another is a taxable event for fund owners, but not for owners of variable annuities.

Mutual fund proponents compare their funds with variable annuities as if the owners of funds and annuities never make changes to their holdings. This is rarely the case. When the income tax burden and other costs of these transactions are explained to clients, the case for owning variable annuities rather than mutual funds becomes more compelling.

7

Mutual fund ownership - unlike VA ownership - may subject Social Security income to taxation.

Single taxpayers who have adjusted gross incomes of $25,000 or more and married couples with adjusted gross incomes in excess of $44,000 are subject to paying ordinary income taxes on from 50 percent to as much as 85 percent of their Social Security income. This additional tax burden can be a major problem for retired persons who have large mutual fund portfolios.

Example

Jack is 65 years old and has pension income of $20,000 a year and Social Security income of $10,000. His mutual fund portfolio is worth $150,000. Although Jack does not need money from his mutual funds, the fund annually distributes $15,000 in capital gains to Jack. This distribution increases Jack's annual income to $45,000, making his Social Security check partially subject to income taxes.

Had Jack held his mutual funds within a variable annuity, none of his Social Security income would be subject to income taxes because gains made within VAs are tax deferred and do not count in determining whether Social Security retirement income will be taxed. Retirees frequently ask if shifting their mutual funds to a tax-free bond fund would solve their problem. The answer is no. Unlike tax-deferred income, tax-free income must be taken into consideration when determining whether Social Security is subject to income taxes.

8

Capital gains rates and holding periods can change.

Mutual fund proponents treat the existence of long-term capital gains rates of 20 percent and the recently reduced holding period of 12 months as if they were etched in stone. Nothing could be further from the truth. History shows that capital gains rates and holding periods fluctuate over time. A future increase in the long-term capital gains rates would increase the tax advantage of VAs over funds. Even if Congress does not raise current long-term capital gains tax, it could adjust the holding period. A longer holding period would result in fund investors having to pay much higher ordinary income tax rates on their holdings.

9

Congress may change our current tax system.

Tax reform is always possible. If our current income tax system is replaced with a sales or consumption tax - which is one possibility - long-term variable annuity owners will reap a huge windfall because they have deferred income taxes for many years.

Congress already has embraced the idea of tax-free retirement income. Roth IRAs allow people to save for retirement and ultimately receive tax-free retirement income. Proposed tax laws include provisions for Roth 401(k)s. Except for individuals with large retirement incomes, Social Security is a form of tax-free retirement income. Moving to a non-income based tax structure and allowing retirees to make income tax-free withdrawals from 401(k)s, 403(b)s and variable annuities may be the next step in this process. Once clients understand the possibility that our current income tax structure may change, they might find it more prudent to defer paying income taxes today by investing their after-tax dollars in variable annuities rather than in funds.

Even if it is not replaced, our current income tax structure is likely to be simplified. Most simplification proposals involve some form of a flat tax. If a flat tax of, say, 17 percent were adopted, both mutual fund owners and variable annuity owners will be subject to the same income tax burden in retirement. A mutual fund owner may well question whether it was worth paying 20 percent or more in income taxes on his mutual fund holdings over the years only to find himself in a 17 percent tax bracket at retirement, especially if his neighbor who deferred all income taxes with variable annuities winds up in the same 17 percent tax bracket.

10

Beneficiaries frequently receive more from VAs than from funds regardless of any step-up in basis.

The concept of stepped-up cost basis allows beneficiaries who inherit mutual funds to treat such funds as if they purchased them on the decedent's date of death for their fair market value on that date. When beneficiaries later sell mutual funds, they only pay capital gains taxes on the difference between the sale price and the market value of the funds on the date the prior owner died. This is true even though the prior owner may have paid much less for the funds.

Variable annuities do not get a stepped-up cost basis when the owner dies. Beneficiaries must use the same cost basis as the decedent and must pay ordinary income taxes on the difference between the decedent's cost basis and the value of the annuity when they liquidate any annuity received from the decedent. Fund advocates claim that receiving the stepped-up basis makes funds a better investment. But this isn't the case.

Example

Suppose Ellen invested $50,000 in a mutual fund 15 years ago that grew at 13.65 percent annually. Each year, taxes on her distributions reduced this growth to 10.92 percent. Ellen recently died and left her mutual fund, which represented all her assets, to her four young grandchildren. The fund was worth $236,656, and the grandchildren received the full amount because the inherited mutual fund was unreduced by income taxes.

At the same time Ellen bought her fund, Frank bought a $50,000 variable annuity with all his assets. It also grew at 13.65 percent, but due to the costs associated with the annuity, the rate of return was reduced to 13 percent. Frank recently died and left his annuity, now worth $312,714, to his four grandchildren. The annuity proceeds paid to the grandchildren were subject to $54,980 in ordinary income taxes, reducing their inheritance from $312,714 to $257,734. But this was still $21,078 more than Ellen's grandchildren received even though they paid no income tax on their distribution.

11

At retirement, VAs can provide tax-advantaged income that funds can't.

At retirement, a variable annuity owner may elect to receive a lifetime stream of income from his annuity. When this annuitization occurs, payments made by the annuity company to the annuitant are treated in two ways. The portion representing growth in the investment - and just that portion - is subject to ordinary income taxation. The portion representing a return of the annuitant's investment is not subject to tax. This special tax treatment makes receiving income from an annuity less of a tax burden than receiving income from a mutual fund portfolio.

Example

Mike is 71 and retired. The $60,000 he has invested in a variable annuity has grown to $120,000. He annuitizes, and starts to receive $12,000 a year for life. By electing annuitization, only $7,500 of Mike's annuity payment is considered taxable income; the remaining $4,500 is a tax-free return of Mike's investment.

If Mike had invested $60,000 in a mutual fund that had grown to $120,000, he could have duplicated the tax advantages of annuitization by keeping detailed investment records, carefully selecting which funds to sell, timing sales precisely and complying with IRS guidelines dealing with the taxation of mutual funds. He would not have received the annuity's guarantee of a $12,000 income for life, however.

12

VAs are not included in estates.

Even if the estate tax is reduced or the exemption increased, variable annuities have an edge over funds because they are considered non-probate property in all states. As a result, VAs - but not fund assets - are exempt from estate taxes and protected from creditors of a deceased annuity owner.

Example

Melissa died in an auto accident that was her fault. In a lawsuit, the injured party won a $700,000 verdict, but was entitled to recover only Melissa's auto insurance coverage of $100,000. The proceeds of Melissa's $600,000 annuity went to her beneficiaries - her four minor children. Had Melissa owned $600,000 in mutual funds, the funds would have been part of her estate and been lost to the verdict.

To hear John Huggard discuss variable annuities is to hear a true believer. But Huggard isn't an insurance executive - he's an attorney, Certified Financial Planner and lecturer at North Carolina State University in Raleigh. He believes mutual funds belong in qualified retirement plans. But for after-tax investing, the tax-sheltered umbrella of the VA more than offsets its slightly higher costs. Huggard, who spoke at Raymond James' recent annual advisor meeting, shares his views. - The Editors