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Tips for Variable Annuity Investors

Investing in a variable annuity may seem like a great way to guard your wealth, but variable annuities are not for everyone. Variable annuity investments are suited only to certain types of investors.

Read on to learn if you fit the profile of a variable annuity investor, when variable annuity investments are not for you, what you should do and consider before investing in variable annuities, and what you can do if you wish to give up your existing annuity investment.

The Profile of a Variable Annuity Investor

Investment goals

Variable annuities are for people whose primary investment goals are income security and capital preservation.

Specific goals vary across different types of annuity products. Those who choose to receive a regular income for life are obviously income-oriented; they want to be assured of a regular income even if they are no longer employed.

The returns of investments made within an annuity account also generally beats the yields of regular savings accounts. This makes it possible for someone to beat (or break even with) the loss of capital caused by inflation.

Of course, variable annuity investments may be some of the most expensive investment products out there. Consider this before deciding to invest in variable annuities.

Risk Tolerance

Variable annuities are for people who have moderate levels of risk tolerance. Annuity accounts are often invested in mutual funds, which are less risky than direct stock, bond or bill investments on account of their innate diversification, among other things.

Time Horizon

Variable annuities are also for people who have a long investment time horizon. Examples include young professionals saving up money for retirement.

Variable annuity contracts are not recommended for people who have short-term investment goals. Variable annuities come with steep surrender penalties, among other fees.

There are cases, though, when someone with a short investment time horizon may find a variable annuity a good option. For instance, someone who is very near his retirement age can purchase a variable annuity with a shorter-than-usual accumulation phase (and, probably, higher purchase payments). People have been known to use variable annuities as a "catch up" retirement plan since IRA and 401k plans have contribution limits while variable annuities don't.

When Variable Annuities Are NOT for You

When is taking out a variable annuity contract not recommended?

You wish to provide for your heirs

Variable annuities are not for people who primarily wish to provide for their heirs. They are for people who want income security for life.

While variable annuity investments do have death benefit guarantees (some even offering stepped-up death benefits), there are already products out there - mainly life insurance policies - that can provide this same benefit. You don't really need a variable annuity if you simply want to ensure that your heirs will have enough to live on when you pass away.

You already have a qualified retirement plan

Variable annuities are also not for people who already have retirement plans like IRA or 401k. Such plans already provide tax advantages.

If you already have an IRA or a 401k account, you should maximize your contributions to these plans first before you allocate after-tax dollars to a variable annuity account. Moreover, do not put a variable annuity account under your IRA or 401k plan. That would be extremely pointless.

If you want to grow your assets more aggressively

If asset growth rather than capital preservation is your goal, you should invest directly in stocks, bonds, funds, etc. Direct investments mean you won't have to pay the insurance companies the numerous fees they charge their variable annuity investors. Your assets (and your income from them) can also grow apace with the actual performance of the products in your portfolio. In variable annuities, your annuity payments do not grow as much as your investments do.

Before Investing in Variable Annuities

The following are things you should note and consider before you invest in a variable annuity:

  • Assess the available investment options. Do you like the available investment choices? If not, perhaps you should look around for a different annuity that offers your preferred investment options.
  • Are you sure you won't need the money you're investing any time sooner than the payout phase? Before you invest in a variable annuity, ascertain that you can get by without dipping into your annuity account, at least until the surrender period (when a surrender fee is charged) is over. If you really want to minimize penalties, make sure you don't need your money before you're 59 ½. The federal government may charge you a 10% penalty tax for withdrawing or surrendering your annuity before that age.
  • It's best that you invest in a variable annuity only the money you can afford to spare. Do not carelessly liquidate your assets (say, your home equity) just so you can buy a variable annuity investment.
  • Note that investing in a variable annuity may be really expensive. Be sure to figure the costs in when computing your potential returns.
  • Activating extra or optional features or benefits may mean more expensive charges and longer surrender periods. Before you choose to activate an optional benefit, therefore, make sure you actually need the benefit and you can't get the same benefit at a cheaper cost somewhere else.
  • Variable annuities, by their very nature, mean variable annuity distributions. If you take out a variable annuity, you must be prepared for the possibility that your annuity payouts may decrease through time, and the amount of future payouts may be much less than what you actually need for daily subsistence.
  • Understand that variable annuity withdrawals and distributions are taxable at the prevailing income tax rate rather than the prevailing capital gains tax rate, which is lower.
  • Do not forget that it is best to keep variable annuities and other qualified retirement plans separate. Do not buy a variable annuity through your IRA or 401k account.
  • Before you take the final plunge, ask for professional financial advice, preferably from someone other than the person selling you the annuity. Furthermore, don't forget to read the annuity's prospectus thoroughly.

Tax-Free 1035 Exchange

What if you already have a variable annuity but want to replace it with another annuity product? A new annuity may offer better investment options, higher income guarantees, larger benefits, etc. Whatever your reason for wanting the change, you can do exchange an existing annuity for another annuity, tax-free, under the provisions of the section 1035 of the U.S. Tax Code.

Specifically, under a 1035 Exchange, the investment gains and earnings of an existing annuity account are not charged capital gains and income taxes if transferred fully or entirely to your new annuity account.

Note that you cannot cash-in your existing annuity account and use part or all of the proceeds to purchase a different annuity product. You must not receive cash for the replacement to qualify as a tax-free exchange. To ensure that replacing your existing annuity with another will be completely tax-free, talk to a tax professional.

Before you actually do a tax-free exchange, however, you should carefully consider the costs of surrendering your existing annuity. If you are still within the surrender period, you will have to pay your current insurance company surrender charges for giving up your annuity account.

You should also consider the costs of the new annuity. How does its fees (e.g. mortality and expense charge) compare to your existing annuity's fees? On the surface, the new annuity may seem to provide more benefits, but will it also eat up more of your capital with its greater fees?

Note, too, that a new annuity means you have to undergo a new surrender period. If you are near your target investment timeframe (say, you are near retirement), perhaps you should just stick to your existing annuity so you can get your money free and clear (except for taxes) when you actually need it. Otherwise, you may have to wait several years more before you can enjoy your annuity savings.

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