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more_legal_areas variable_annuitiesVariable annuities allow individuals to invest in a variety of investment funds, including stocks, bonds and money market portfolios, providing returns based on the performances of the funds. With a variable annuity, there are two phases it will go through, including an accumulation phase and a payout phase.
The accumulation phase involves the purchase payments that can be allocated to various investment options. Money allocated to each mutual fund investment option increases or decreases over time, based on its performance. Variable annuities also allow investors to allocate part of their purchase payments to a fixed account, which, unlike a mutual fund, will pay a fixed rate of interest.
Earnings inside the annuity grow tax-deferred, and the account is not subject to annual contribution limits like other tax-favored vehicles, such as IRAS and 401(k)s. Withdrawals made after age 59 ˝ are taxed as income, and earlier withdrawals are subject to tax and a 10% penalty.
During the accumulation phase, the investor can typically transfer their money from one investment option to another without paying tax on investment income and gains, but the insurance company might charge for transfers. “Surrender charges” have been the source of controversy, especially in recent years, and now a number of states have been implementing laws to increase the oversight and scrutiny of some annuity sales with special emphasis on provisions that limit the amount of time annuity sellers can impose surrender charges.
In July 2005, New Jersey began enforcing its Senior Citizen Investment Protection Act, limiting how long annuity sellers can impose surrender charges, becoming the third state – along with Utah and Washington – to limit to no more than 10 years the length of time insurers can impose surrender chargers. Though the most important source of information regarding a variable annuity’s investment options is the prospectus, looking through and trying to actually figure out how the guarantee withdrawal benefit works can be difficult. The complexity of annuities makes it difficult for investors to distinguish between a suitable investment and a bad one.
At the beginning off the payout phase the investor can receive their purchase payments plus investment income and gains as a lump sum or as a stream of payments at regular intervals. When a policy pays out regular income it is said to have been annuitized. As long as the money remains in the policy, the investments incur no tax, but fewer than three percent of policies are annuitized. Most people either take out the funds or die before annuitizing.
Most variable annuities have high costs, and brokers selling them receive generous commissions that remain at the same high rate regardless of how much is invested. With mutual funds, commission percentages are reduced as the investment amounts increase. With variable annuities, capital gains earned from investments within a variable annuity are not eliminated by death, so whoever receives the money pays ordinary income taxes at high rates on all of the earnings accumulated from the beginning, which is also unlike the treatment of funds held outright where death cancels the capital gains and investment tax costs become the values at the owner’s death.
Though investments compound tax-free and the insurance company provides limited guarantees against stock market losses, variable annuities can require high income taxes on funds withdrawn from a variable annuity. Variable annuities also have policy values that are diminished by high costs along the way, and capital gains are not eliminated by death. If the policy is not annuitized during the first 15 years it usually does not pay since only after 15 years of compounding in a tax-free environment do the annuities begin to pay off.
Before purchasing a variable annuity an investor must learn as much as possible about what benefits it will specifically provide them, as well as the charges involved. Financial professionals selling variable annuities have a duty to advise potential investors whether this form of investment fits the potential client’s individual needs, but the best way to protect your retirement and investment funds is to know exactly what you are doing with your money by educating yourself and asking important questions.