ESTATES AND TRUSTS

April 2000

ARE TAX-DEFERRED VARIABLE ANNUITIES APPROPRIATE FOR AN INVESTMENT PORTFOLIO?

By Alan D. Kahn, CLU, ChFC, CPA, and The AJK Financial Group

A variable annuity is an insurance contract that provides a future income: either a stream of payments guaranteed to last a lifetime, some other form of systematic withdrawal, or a lump sum. Because the guarantee of a lifetime income depends on the claims-paying ability of the insurance company that issued the variable annuity contract, planners and their clients should consider only top-rated insurers.

A variable annuity can increase retirement savings, control tax liabilities, manage or limit investment risk, and supplement lifetime income. The decision to purchase a tax-deferred variable annuity should be carefully tailored to the individual's needs, goals, and portfolio. When considering an annuity, planners and consumers should look for programs offering many investment options with little or no surrender charges or other fees.

Investment Options

An appealing feature of variable annuity programs is the variety of investment options, typically ranging from conservative vehicles such as money market or bond subaccounts to aggressive choices such as domestic or international stock subaccounts.

Many popular variable annuities offer different mutual fund accounts and fund families, giving the owner tremendous flexibility as investment goals and needs change. The owner can switch funds within a fund family, as well as trade between fund families, making transactions at no cost or taxation because they occur under the umbrella of a tax-deferred annuity.

Special features of variable annuities include the following:

* Amounts invested grow tax-deferred until withdrawn. Nonqualified annuities have no minimum distribution requirements, and the tax-deferred dollars can accumulate indefinitely.
* A guaranteed minimum death benefit. Generally, this feature stipulates that if the investor dies while the contract is still accumulating, the beneficiaries are guaranteed to receive a specified sum. This is extremely beneficial if the investor dies during a period of poor investment performance. If the contract's value is worth less than the original investment, the death benefit ensures that the beneficiaries receive no less than what was originally invested. Some companies, for an additional nominal fee, offer the option of locking in a new death benefit guarantee based on new account values every one to three years.
* Some companies offer a 5% simple interest death benefit, which pays a death benefit of the greater of the current value of the contract or the sum of purchase payments accumulated at 5% interest. This benefit, also available for an additional nominal fee, allows the owner to aggressively invest excess dollars while knowing that the value is guaranteed in a depressed market.

Tax Issues

The tax-deferred growth within an annuity is not counted for Social Security purposes. However, withdrawals prior to age 59 wQ are subject to a 10% IRS penalty, with certain hardship exceptions. In addition, distributions are subject to ordinary income tax rates as opposed to capital gain rates. *