Variable Annuities Take on Mutual Funds

Physician's Money Digest, March15 2003, Volume 10, Issue 5

Variable annuities (VAs) have long beengiven a bad rap. The reasons for this aremany—including the general lack ofunderstanding about how VAs work. The generaltax-deferral vs tax-free vs after-tax earnings debatefuels much of the discussion. There are severalreasons for VA usage. And there aredistinct advantages to using them overinvesting directly in mutual funds.


Since mutual funds themselves arenot taxable entities, any net capital gainsthe fund experiences must be passedthrough to investors on a 1099 form.Last year, many mutual fund ownersfound themselves paying rather largetaxes on capital gains, even though thevalue of their fund shares had dropped.The only thing worse than paying taxeson money you received is paying taxeson money you didn't receive. Since mostmutual funds are actively managed,these gains are created when fund managerssell holdings at a profit inside thefund over the course of the year to supportthe net asset value. These gainsmust be passed on to the fund owner, regardless ofthe change in the funds' net asset value.

This unrealized income may disqualify you forcertain tax credits, increase the taxability ofSocial Security benefits, and reduce your deductionsfor medical expenses and other write-offsthat must exceed a certain percent of yourincome. This unrealized income could also affectdeductibility for certain IRA contributions.

Inside a VA, any gains posted by the funds arenot distributed to the annuity holder, and anygains that the investor might see in transferringfrom one fund to another within the annuity arealso sheltered from current taxes.

When you retire, you may decide to move yourgrowth-oriented funds to income funds.Unfortunately, any growth you have inthe funds will be taxed when you sellthose funds to purchase income funds,immediately reducing the value of theholdings. Even if you move within thesame fund family, the gains will betaxed. Unless you use tax-free funds forincome, which typically pay less, theincome will be taxable.

Inside the VA, funds can be movedwithout incurring any taxes, regardlessof the amount of gains the funds mayhave. Although distributing incomefrom an annuity will create taxableincome, it may be done with more fundsinvested by avoiding the current tax onany gains when you set up your incomestream. An additional advantage can behad if the VA is annuitized, wherein theinsurance company will provide a guaranteedlifetime income stream in exchange for theprincipal in the contract. A portion of each paymentis considered a return of principal, reducingthe amount of income taxed in any given year.

Annuities are considered insurance contracts.Thus, when a VA's payments are disbursed directlyto a named beneficiary, they are not subject to probate.Probate not only delays the payment of fundsto the ultimate beneficiaries, but it can also erodethe value of the resulting payment due to the costsassociated with probate administration.

One of the elements of analyzing mutualfunds is looking at fund size (ie, total assets). Inmany cases, returns on mutual funds can drag asthe assets in the funds grow. When a fund thatexists in the marketplace is added to a VA, a differentpot of money must be set up and managedinside the annuity, even though the fund mayhave the same name and management as the correspondingmutual fund on the outside.

Since VAs are newer innovations than mutualfunds, these funds often have smaller total assets,allowing them to be managed more efficiently,often creating better returns than their regularmutual fund counterparts. Though this may notalways be the case, it is important to compare VAfund returns to their nonannuity counterparts.


The favorable capital gains treatment ofnonannuity investments is something that is oftenbandied about and changed by Congress almostevery time tax law changes are proposed. VAs aregoverned by the rules applying to insurance andannuity contracts, which have been on the booksfor many years, and to date, efforts to changethem have been mostly unsuccessful, which can'tbe said for changes to the tax treatment of mutualfunds and other standard investments.

Dismissing the benefits of a VA without considerationmay be a mistake. Annuities are for long-termneeds, and if your objectives for any investmentmoney is not long term, the VA is not the wayto go. For long-term retirement needs, however, VAbenefits can outweigh those of mutual funds.

Patrick J. Flanagan is a New Jersey-based registered representative affiliated with First Montauk Securities, member NASD/SIPC. He welcomes

questions or comments at 800-969-0899. Any opinions expressed are the author's

and do not necessarily reflect the opinions of First Montauk Securities

or its officers, directors, or affiliated registered representatives.