Variable annuities and current tax law.

• Author: Williams, Wayne

With the reduction in capital gains rates in the Taxpayer Relief Act of 1997, will the tax deferral investors received within a variable annuity continue to compare favorably to investments made outside a variable annuity (e.g., in a regular brokerage account)?

A variable annuity (offered for sale exclusively by life insurance companies effectively) is a group of investments consisting primarily of mutual funds and, in most situations, includes a guaranteed fixed-return investment choice. What distinguishes a variable annuity is that the investments are enclosed within an insurance "wrapper" that allows the investor to earn dividend and capital gain distributions, and realize gains from the sale of shares of the enclosed mutual funds on a tax-deferred basis. The insurance wrapper is made available to an investor at a price--additional mortality and administrative expenses over and above those found in all mutual funds, including those within the wrapper. A variable annuity is most widely sold as a form of supplemental retirement plan, as tax penalties exist (with only certain exceptions) that affect withdrawals made before the age of 59 1/2. All appreciation in total value in excess of an investor's original contribution is taxed when withdrawn, at ordinary income rates. Systematic withdrawals made over an investor's life expectancy are available, with taxable appreciation and return of original contribution recognized on a pro rata basis under Sec. 72. "Nonannuity" payouts are "penalized" by being treated as gain first (subject to ordinary income tax rates until the value remaining within the annuity is reduced to contributed basis), and then as capital return.

Many insurance companies sell variable annuities through agents who earn commissions on sales, while others are direct-marketed. How a product is marketed usually has a dramatic effect on its costs, with commission-sales products having average additional wrapper-related expenses of nearly 1.5%. The more competitive products, found through the insurance arms of certain discount broker/dealer and mutual fund companies, are far more cost-effective, with wrapper-related expenses generally averaging between 50 to 80 basis points.

The reduction in capital gains rates has had no effect on the taxation of variable annuities; all gains, whether ordinary or capital when earned, are ultimately taxed on withdrawal at ordinary income tax rates. However, a reduced capital gains rate is a...