Tax-favored annuities: good for your portfolio?

Nation's Business, June, 1993 by Peter Weaver

Under Clinton administration proposals, the effective marginal tax rate for middle-and upper-income individuals could jump to nearly 40 percent from 31 percent.

When this kind of tax change hits investors, many of them look for shelters. One of the few left is a variable-rate annuity.

Annuities are sold by insurance companies and by mutual funds associated with insurance companies. Although there are annual limits on how much you can invest in an Individual Retirement Account, 401(k) plan, or Keogh, there are no such limits on annuities.

Nonetheless, you should proceed carefully when you are investing in annuities, says Jennifer Strickland, editor of a newsletter on variable-rate annuities; it is published by Morningstar, a rating service in Chicago. "Before investing in an annuity," she says, "you must first make sure that you have maximized investments in any 401(k) or other employment-based, tax-deductible retirement program."

Employment-based investments provide a double tax benefit. You defer taxes on investment earnings, as you do with annuities, and you also defer taxes on the money you contribute every year.

The two basic kinds of annuity investments are fixed-rate and variable-rate. The fixed-rate annuity is somewhat like a certificate of deposit. It guarantees a specific rate of return, though the rate is lower than what you may be able to get through a variable-rate annuity.

"With a variable-rate annuity," Strickland says, "you're basically investing in a mutual fund wrapped in an insurance-annuity plan." The insurance feature allows it to be treated as a tax-deferred investment vehicle under the tax code.

Although variable annuities can work wonders for many higher-income investors, they're not for everyone. "I usually don't recommend variable annuities for people who are less than 40 years old," says Arthur Gelman, a financial planner with the Commonwealth Financial Group, in Bethesda, Md. "This type of tax-favored investment is better suited for people in their 50s and 60s," he explains, "because you can be hit with a 10 percent tax penalty if you cash in before age 59-1/2." The older you are, the more flexibility you have.

The sellers of variable annuities also impose penalties for cashing in early. You have to hold your investment an industry average of six to seven years before you can take money out without incurring an early-withdrawal penalty.

So, you should be in for the long term, and thus the investment performance of any mutual fund you choose is important. Also important is the size of the basic management and insurance fees charged by the seller.

"When you are in for the long haul," says Morningstar's Strickland, "it's a good idea to aim for aggressive growth in stock funds or high-yield bond funds." To make the most of your tax-deferred status, she explains, you need high capital gains or high income from your investment.

The ideal variable annuity will have a high rate of return over the years and low service fees. In its annual Variable Annuity/Life Source Book, Morningstar has a "Star Rating" that simplifies performance and cost comparisons. This service is $195 a year, but brokers, financial planners, and most major libraries have it.

Some caveats: Strickland says you should resist adding special features such as "fancy death benefits," because they add too much to the overall cost.

Gelman says he doesn't recommend choosing to have the funds distributed in an annuity (getting guaranteed monthly payments for life) because "it's a gamble between you and the insurance company as to how long you're going to live."