In a recent post, I explained the basics of variable annuities (VAs) and their components. I also shared how we were sold a variable annuity that we later realized was not in our best interest. Hopefully, that post will prevent others from repeating our mistake.
As mentioned in the previous article, our experience is (unfortunately) fairly common. If you were already sold a variable annuity that you do not want, you may have figured out by now that getting out of it will be a financially painful process.
Variable annuities typically have surrender periods ranging from 6-10 years. This forces you to choose between holding the investment with high ongoing fees, or paying a substantial penalty to sell it. Even if you have already held the VA beyond the surrender period, you may face equally challenging tax consequences in order to sell the investment.
Today, I will outline the steps, thought process, and a few tips that we have found helpful when figuring out what to do with the variable annuity we were sold. We used these same steps when working through the process with some family members who were in similar, but slightly different, situations.
Step 1: Figure Out the Purchase Date
If you happen to have recently bought a variable annuity and are having second thoughts about whether it is appropriate for your needs, you may be in luck. Variable annuities have a “free look period,” during which you can review your contract. You can also get out of the investment without penalty. This period varies based on different state laws and insurance companies, but typically is 10-30 days.
I experienced this scenario with my sister-in-law, who rolled over a 403(b) account when switching jobs last year. When we stopped at their house the following weekend, she told me she just did the rollover and asked me to take a look. She was sold a variable annuity that she did not fully understand. She contacted the company the following Monday to discuss her options and was able to get her money back with no fees. Then, she rolled the money to another financial institution with more suitable investment options.
If you find that you were sold a variable annuity that is not in your best interest, and you discover this within the “free look” period, you have options. You can then either simply roll over the account again, if it is in a tax advantaged account. Or, you can choose a different investment, if in a taxable account.
What if you are out of the “free look” window? Well, the process of getting out of a variable annuity is more complicated. It’s more costly, as well. If this is your situation, you will have to go to step 2.
Step 2: Determine the Surrender Charge of the Annuity
There are high commissions paid to those selling variable annuities, as well as insurance risks. Therefore, the vast majority carry “surrender charges.” These charges will vary considerably based on the contract and the carrier, but can range from 6-10 year schedules.
The surrender charge is generally a percentage of your assets and is tiered, gradually decreasing over time. For example, an annuity with an eight-year surrender period may charge 8% in year one, gradually decreasing to 4% in year 8. After year eight, the surrender period and accompanying charges end.
If you have held your variable annuity for a long time and are out of the surrender period, the bad news is that you have already paid considerable fees on your investments. The good news is that you do not have to face any further decisions about surrender charges. You can just move on to Step 3.
Maybe you have bought your variable annuity more recently. If so, you will need to read your prospectus carefully and do some calculations. To find the cost of selling the variable annuity, you have to determine what the surrender fee is based on your contract terms. To determine the cost of staying in the annuity, you need to examine all of the fees that you pay on your assets annually, as well as the number of additional years that you would have to hold the investment before exiting the surrender period.
You can then make a reasonable estimate as to your best choice. You can decide if it’s better to hold onto a VA with high annual fees and limited investment options. Or maybe it’s best for you to just pay the surrender fee. Then, you would have the option to choose from a wider array of investment options with lower fees, outside of the annuity.
We elected to do this analysis ourselves, but luckily my wife is a spreadsheet wizard with actuarial and analytical backgrounds. It may benefit you to consult with a fee-only financial advisor to assist with this analysis.
I have one word of caution before you pay more fees for high-priced advice. Insurance companies that sell these products are massive companies with teams of lawyers and actuaries on their side to insure that they do not lose money. While professional advice may be useful, I have not read anything indicating that you can expect to find a loophole in the contract. It’s highly unlikely that you will get out of the investment without some penalty.
We determined that either paying the surrender fee or holding the annuity with high annual fees would result in substantial costs, and there was no clear good choice. It was simply a matter of whether it was better to pay all at once with the surrender fee or slowly with the annual fees and expenses. We considered these unpleasant financial options with the following analogy: Paying the penalty is like being stabbed and hemorrhaging out a large sum of blood, while paying the ongoing annuity fees is like bleeding out by 1,000 small cuts. There is no pleasant option and the end results are similar.
Once you have examined the options, you can decide how to move forward. If you are out of the surrender period, the decision is easy. If not, you may still determine that it’s in your best interest to pay the surrender fee to exit a variable annuity. The next step will help you complete your analysis.
Step 3: Determine the Tax Implications
If you own a variable annuity in a tax sheltered account, such as a rollover IRA, then the tax sheltered account trumps the variable annuity. You can roll your investments to any other investment with any brokerage company inside of the tax deferred vehicle with no tax penalties. No further analysis is necessary, although it’s always wise to consult with a tax professional before making a decision.
If you own a variable annuity outside of a tax advantaged account, you will face some further tax implications. These will further complicate your analysis. This is an area where it would likely be very wise to consult with a tax professional. Doing so may save you from making any potentially expensive mistakes. There are two key factors that must be considered.
The first factor is your age. You will face a 10% penalty on any investment gains for withdrawing money from a variable annuity prior to age 59 1/2. There are exceptions to this rule, similar to those governing an IRA.
The second factor is the appreciation on the initial investment amount. Any investment gains of a variable annuity are taxed as ordinary income upon withdrawal. This means that any gains will be taxed at your marginal tax rate. They can even push you to a higher marginal tax rate! This can mean paying taxes as high as 39.6% for the highest earners.
Read More About Current Tax Brackets
When doing this analysis, remember to not only factor in the direct tax costs, but also the consequences of increasing your recognized income for a given year. For example, recognizing a large sum all in one year could increase your recognized income to a level where you can no longer deduct a previously deductible IRA contribution.
This could have a domino effect. It could disqualify you from being able to contribute to a Roth IRA. It could increase the tax rate applied to other taxable investments. Or, it could push you over “subsidy cliffs,” if buying health insurance through ACA exchanges.
Consider an example I encountered. I talked with a couple who were sold a variable annuity over a decade ago, when they inherited a sum of money that they then wanted to invest. Despite the high fees, this investment doubled in value with the bull market over the past decade. Even with their low income in retirement, the investment gains had a large impact. If taken as a lump sum, it would push them from a 15% marginal tax bracket to a 25% bracket. This would mean that a substantial portion of the gains would be subject to a 25% tax.
Indirect consequences of this lump sum inflating their recognized income for the year would be significant. It would include tax rates on their taxable investments increasing from 0% to 15%. Also, the wife is not yet Medicare eligible, and must buy her health insurance. Thus, recognizing this income all in one year would result in losing a substantial portion of her ACA health insurance subsidy. Factoring in the direct taxes on the investment gains, plus the indirect tax consequences of recognizing this income as a lump sum, would result in a five-figure increase to their tax bill. All of that, just to exit the variable annuity contract.
If you are over age 59 ½ (or are willing to pay the 10% penalty on gains), have small investment gains, and/or are in a low marginal tax bracket, it may be in your best interests to sell off a variable annuity. Even despite the tax implications. However, for many with taxable variable annuities, these tax provisions will make it very costly to exit even a very bad VA contract.
This takes us to our final option for those stuck in a bad variable annuity contract, but for whom it does not make sense to sell the assets due to tax effects. They can perform a tax-free 1035 exchange.
This means that they will transfer their variable annuity to another variable annuity, without any tax consequences. You can find no-frill, relatively low-fee, variable annuities with no surrender fees from companies such as Jefferson National and Vanguard.
However, remember that even these lower cost variable annuities will still be more expensive than investing outside of an annuity. You also will have to pay any applicable surrender fees on the original VA before completing the 1035 exchange. This is because you will be buying a new annuity in the exchange.
As you can see, getting out of a bad variable annuity contract is a very complicated, and often expensive, process. Unfortunately, variable annuities are common investment products despite their high fees and complicated tax structures. This is because they are pushed aggressively by the financial industry, by those who make a handsome commission on their sale.
If you own a bad variable annuity that you no longer want, this will hopefully provide options for you. Now, you can start the process of moving forward to a more favorable investing strategy. Be careful and seek professional advice as needed to assist you in the process. Mistakes made while selling off a variable annuity can be even more costly than staying with it.
Have you had a bad experience with a variable annuity? Did you decide to stick with it or get out?Topics: Investing