Most investors have a common goal for their investment activities: accumulate positive returns on their investments and grow their wealth. Many have retirement in mind and look to tax sheltering investments like variable annuities offered by insurance companies or traditional individual retirement accounts established with Internal Revenue Service (IRS) approved institutions. Some investors might invest in several of these and others might be trying to decide between one or the other. It’s definitely important for both to understand the differences between a traditional IRA versus variable annuities.
What are traditional IRAs and variable annuities?
Traditional Individual Retirement Account (IRA) - is a plan that allows individuals to set up an account at an institution approved by the
IRS that is funded by periodic payments (contributions) from compensation. The accumulated funds can be invested and any capital gains or earnings aren’t taxed until they are distributed. There are many rules and exceptions regarding almost every aspect of IRAs,
Variable Annuity - is a contract between a purchaser (annuitant) and an insurance company that allows the annuitant to pay a lump-sum or periodic payments to the company in exchange for a lump-sum or periodic payments at some future date that is adjusted for the performance of the annuity’s investment portfolio. The annuitant usually gets to choose the investment mix for their annuity’s portfolio. Variable annuities differ from the more common fixed annuities in that the distribution of periodic payments for variable annuities are exposed to the long term market risk of the underlying investments. Each distribution payment is adjusted upward or downward as the returns on the investments within the contract fluctuate. There is usually no guarantee for the amount of the periodic payment but some variable annuity contracts actually do offer a minimum distribution benefit guaranteeing a minimum payment to the annuitant. These annuities appeal to investors who are concerned about their distribution payments losing value to rising costs of living over the years.
Traditional IRA - contributions are subject to limits and rules regarding how much can be contributed with an excise tax on excess contributions. The limit is usually the lesser or a certain amount that can change each year ($5,000 ($6,000 if over age 50) for 2010) or the taxpayer’s taxable compensation. There is also an age limit of 70½ after which a taxpayer can’t make any more contributions.
Variable Annuity - a tax sheltering feature is offered for contributions to variable annuities similar to those of IRAs. They are deductible from taxable income at the time of contribution and the investment earnings can grow tax-free (deferred) from local, state and federal income taxes during the until the time they are distributed.
Traditional IRA - distributions begin at the age of 70½. A minimum distribution is calculated each year using life expectancy tables provided by the IRS. The distributions from a traditional IRA are generally taxable in the year that they are received. There are no exceptions. Minimum distributions are required and there can be a penalty for not complying with this.
If losses in an IRA reduces the investment to less than its basis it is possible to deduct the loss on an income tax return for the current year but the funds in all of investors IRAs must be withdrawn to do this.
Variable Annuity - the distribution date for a variable annuity and the payment period are determined by the investor. The company then uses actuaries to calculate the investor’s life expectancy and determines how much the payments will be. Most investors chose a lifetime payment period. These distributions are taxable income in the year that they are received divided between ordinary income and capital gains. Minimum distributions may be required by the insurance company.
IRAs versus variable annuities receives equal treatment from the IRS. There are penalties for early withdrawals for both IRAs and variable annuities. This is a 10% tax in addition to the regular income tax on amounts withdrawn before the age of 59½.
Charges, Fees & Optional Guaranteed Benefits
The traditional IRA versus variable annuities shows that both can have fees and charges attached to them that depend on such things as what financial institution or insurance company they are with, what the investments are and how the account is managed.
Variable annuities have their own fees and charges that vary from company to company and some of them do lend themselves to criticism. Some common fees are: annual fees, administrative and mortality and expense charges, front-end load charge (sales commission), and surrender charges.
Variables do offer optional guaranteed benefits that can act as insurance for a retirement account. Some of these are: Guaranteed Death Benefit, Guaranteed Earnings Increase Death Benefit, Guaranteed Minimum Income Benefit (GMIB), Guaranteed Minimum Withdrawal Benefit (GLWB), and Guaranteed Minimum Accumulation Benefit (GMAB). Any of these benefits can be added to a variable annuity contract and they all do not cost the same but they can be important to an investor when trying to fit a variable annuity into a retirement investment portfolio.
IRAs can also produce fees and charges. Some of these are: annual fees from financial services firms, transaction fees for the purchase or sale of investments, administrative fees, and fees for managed accounts.
Retirement Plan Objectives
The objectives of any retirement oriented investment are to provide a long term supplement to retirement income. When it comes to the traditional IRA versus variable annuities there are some pronounced differences but they can provide a good retirement next egg as their increasing popularity attests to. There are added benefits of tax deductible contributions and tax-free earnings accumulations before retirement and the probability of lower income tax rates after retirement when they are included in taxable income. IRAs can be pretty straight forward if you understand the rules provided by the IRS. Variable annuities can be a good alternative or addition to a retirement strategy that utilizes IRAs when contribution limits have been reached. Both can incur fees and charges. In the case of variable annuities they can vary quite a bit between insurance companies and salesmen can be overzealous at times. It is quite to an investor’s advantage to do a little homework and gain some knowledge before shopping around and entering into a variable annuity contract and it would also be helpful to do the same for IRAs.
Internal Revenue Service
Steven Merkel,CFP®, ChFC, Getting the Whole Story on Variable Annuities, http://www.investopedia.com/articles/04/111704.asp#13001471462592&close
Denise Appleby, CISP, CRC, CRPS, CRSP, APA, Deducting Losses on Your IRA Investments, http://www.investopedia.com/articles/retirement/05/012505.asp#13002178705972&close
George D. Lambert, The Cost of Variable Annuity Guarantee, http://www.investopedia.com/articles/pf/06/variableannuity.asp#axzz1clZ0vLb2