Variable annuities can be useful estate planning tools in a limited range of circumstances. While using a variable annuity may help to preserve more of your wealth by deferring taxes during your high-income years, high fees can wipe out these savings. More importantly, either you or your heirs eventually must pay the deferred taxes. Consult your financial adviser before making any final decision.
A variable annuity is a tax-deferred investment vehicle that consists of stocks or bonds nestled within an insurance policy. There is no annual limit on the amount of money you can place in the account, but if you withdraw before the age of 59 1/2, you pay a 10-percent early withdrawal penalty in addition to income tax on the amount you pull out.
The beneficiaries of your variable annuity must pay income tax on the value of the account at the time of your death, minus the purchase price. This can be a significant disadvantage compared to a mutual fund, for which your heirs would pay capital gains tax -- usually lower income tax – only on the amount over the fair market value of the account at the time of your death. If you decide to start receiving regular disbursements from the annuity, a process called "annuitization," any money left in the account at the time of your death may go to the insurance company and not to your heirs, depending on the terms of the contract.
A variable annuity carries hefty annual fees. You pay an annual management fee, plus a mortality and expense fee to cover the Guaranteed Death Benefit, which ensures that your heirs will receive at least the original principal, even if the value of the account decreases. This fee is based on the total value of the account, including any accumulated earnings, rather than the guaranteed amount, which is usually smaller. These two fees typically amount to approximately 2 percent of the value of the account annually, compared to the industry average of 1 percent for a mutual fund account. You'll also pay a surrender fee, which could be as high as 6 percent, if you access the fund during the first few years after investment.
Despite the fees, a variable annuity can be useful for estate planning -- for example, if you want greater tax-deferred investment than your IRA or 401(k) allow. A variable annuity also avoids taxes on short-term capital gains that you pay with a mutual fund investment, thus leaving more money for your heirs. Finally, if you need a shelter against creditors, in some states, the money in your variable annuity is exempt from claims by creditors.
A retired federal senior executive currently working as a management consultant and communications expert, Mary Bauer has written and edited for senior U.S. government audiences, including the White House, since 1984. She holds a Master of Arts in French from George Mason University and a Bachelor of Arts in English, French and international relations from Aquinas College.