The Disadvantages of a Tax-Deferred Variable Annuity

by Philippe Lanctot
Variable annuities fit a more aggressive investor profile.

A tax-deferred variable annuity is an investment contract offered by an insurance company that contains a guaranteed death benefit. It also offers the opportunity to earn potentially high market-related investment returns and defer tax on these earnings until you make withdrawals. Before deciding to buy a variable annuity, consider its potential disadvantages to evaluate if this is an investment that suits your needs and financial situation.

Fees

A variable annuity typically carries a number of various fees and charges that may erode the potential higher returns and reduce your tax deferral advantage. A variable annuity might charge an investment management fee to maintain the market-related investments in the contract equal to a percentage of the assets. An insurance charge may be deducted as well. Surrender charges for early withdrawals are common, and many variable annuities charge sales commissions that are a percentage of contributions.

Taxes

Although you invest in market-related instruments with a variable annuity and a substantial portion of your investment earnings come from capital gains, your withdrawals will be taxed at ordinary income rates. This lessens the effects of the tax deferral, as capital gains are taxed at lower rates than ordinary income. Consider investing a portion of your taxable investments in stock-related instruments to take advantage of lower capital gains tax rates, and use fixed income investments in tax-deferred investments such as annuities.

Penalty Tax

Any distribution you receive from the variable annuity before age 59 ½ will incur an additional 10 percent penalty. This restricts your liquidity somewhat and limits your ability to move funds outside of the variable annuity to other investments.

Investment Risk

If you are contributing to the annuity mainly for the tax deferral, you should know that a variable annuity’s investments are tied to the stock market and contain an element of investment risk. Your funds can drop during periods of market downturn.

No FDIC Coverage

Variable annuities are issued by insurance companies and therefore do not receive protection under the Federal Deposit Insurance Corporation, which insures accounts up to $250,000 in qualifying financial institutions. Protection for your annuity investment is afforded by your home state’s Life and Health Guarantee Associations, but in many states the maximum amount of coverage for annuities is $100,000 for accumulated values and payouts.

About the Author

Philippe Lanctot started writing for business trade publications in 1990. He has contributed copy for the "Canadian Insurance Journal" and has been the co-author of text for life insurance company marketing guides. He holds a Bachelor of Science in mathematics from the University of Montreal with a minor in English.

Photo Credits

  • Jupiterimages/BananaStock/Getty Images