Over my 10 plus years in the insurance and financial services industry one of the most constant issues in selling variable annuities is the ability to overcome the high fees typically associated with them. In most cases and when advised effectively, the client will benefit greatly from the guaranteed lifetime income or tax deferral features of these products and will easily outweigh the downside of those higher fees. All this has changed in recent years with the introduction of the Investment Only Variable Annuity or IOVA for short and these products have carved out a niche in the market place that when used effectively can offer a rather unique solution to some specific situations.
IOVA’s have stripped out all of the typical “expensive” components to the traditional variable annuity. Components such as guaranteed lifetime income, guaranteed death benefits or downside market protection. The result has been a simple one, lower fees (some are just a flat $20/month plus advisor fees) and a more simplistic tool to help clients in certain situations. What IOVAs have left is the important tax deferral feature that is often overlooked by the general public. This remaining tax deferral feature can be a powerful resource to those that have substantial assets in non-retirement accounts. Let’s look at some examples of where IOVAs may be beneficial to use:
Example 1: Trusts
For some of our more affluent clients interested in leaving assets to their heirs, a typical strategy will be to use a trust. A trust in the eyes of the IRS is seen as its own individual and as such must pay income taxes every year. The kicker here is that the taxable rates are far higher than they are for an actual person. In 2018 the tax rates for a trust are as follows:
Meaning that if a client has a $1,000,000 trust that they plan to gift to their heirs and they invest conservatively it is very possible that they have received 3% in dividends or $30,000. That trust would be responsible for $9,486 in income taxes ($3,011 plus 37% of $17,500). The result is that a trust that should be worth $1,030,000 is now, after taxes, worth $1,020,514. This tax liability comes due every single year. This client may benefit from using an IOVA because this product is still an annuity and will not have to pay taxes every year and instead will only pay taxes once it is cashed out. In years when the market performs very well it would not be unreasonable to see a $1,000,000 trust have a capital gain of $100,000 or more. The result of a $100,000 taxable gain would result in a tax liability of $35,386. A fairly large tax bill to swallow.
If this same client were to employ a traditional Variable Annuity to try and mitigate tax liability they would still be responsible for the fees of the annuity. While these fees are not typically a line item, they still will have an adverse effect on growth. For example, a typical variable annuity may have fees and expensive of 2.5% resulting in expenses of $25,000 a year for a $1,000,000 account, regardless of performance. The trade off is that the traditional annuity may offer a guaranteed death benefit whereas the IOVA will only pass on the account value.
Example 2: High Income Earners
For individuals with high levels of income there may present a desire to save for retirement above and beyond the limits the IRS sets on retirement accounts. For example, a client has annual income of $500,000/year:
The IRS will put a limit on the amount this client can put into their 401(k) of $18,500/year and their income will far exceed the IRS income limit to contribute to a Roth IRA ($189,000). For this individual should they want to save say 10% of their income ($50,000) this would leave a gap of $31,500/year in savings. What are their options if they are tax conscious? They could purchase a permanent life insurance policy, which will have very high fees and may have a longer surrender period, they could invest in municipal bonds or they could look to an IOVA.
Again, because the IOVA is still an annuity, premiums invested in the IOVA will grow tax deferred until they are withdrawn. Meaning these funds will grow similarly to the client’s 401(k) with the difference being premiums will not be a tax deduction in the year they are made. Additionally, unlike the permanent life insurance option, the annual amount you decided to invest in the annuity can be variable. One year the client may decided to save $30,000 and the next only $10,000. There is not a minimum or required amount needed to save every year. Unlike the life insurance option, there also is no concern of this product becoming a modified endowment contract which could have negative tax consequences later on down the road.
A note of caution. IOVA’s still have to play under all the rules of variable annuities, including the 59 ½ year old rule. This rule states that if funds are withdrawn from any variable annuity prior to age 59 ½ then any gains are taxable at ordinary income plus a 10% IRS penalty. Furthermore, the first dollars out are considered a taxable gain until the client reaches their cost basis, or premium, deposited into the product. This may not be the best solution available to individuals that are planning on taking income from these assets prior to turning age 59 ½. As always you should consult with your personal tax advisor to help determine the appropriateness of this product and should recognize that IOVAs do not have guarantees associated with them and as such are subject to investment risk, including loss of principal. If you feel like you may be a good fit to use one of these IOVAs please contact us to discuss the pros and cons for your individual situation.
Andrew R. Reina
The views and opinions in this newsletter are that solely of Andrew R. Reina and do not necessarily reflect those views and opinions of Fortune Financial Services Inc. or its affiliates. You should always contact your tax or legal professional regarding your specific situation.