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Annuities for beginners
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March 28, 2000: 12:30 p.m. ET
Expert says an annuity offers tax-free growth, regular income payments
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NEW YORK (CNNfn) - You and your spouse are 30-somethings who have maxed out your 401(k)s and Roth IRAs. You have a year's wages in savings. But you're concerned about the tax implications.
In response to a reader's question, Don Boegel, a certified financial planner from Plymouth, Minn., and a member of the Financial Planner Association, said an annuity might be a good fit in your long-term plans.
Ask the experts a question.
My wife and I are looking for tax-advantaged investment tools. We've heard a little about variable life annuities. Although I do understand that the contributions are not tax-free, the earnings and growth are. What I am looking for is a layman's explanation of variable life annuities. How do you create one, contribute to one, and how do the taxes work? How frequently can you contribute, and are they a good investment tool? We already have maxed our 401(k) contributions, have Roth IRAs, and we have almost a year's wages in accessible savings. A problem is the tax issues on the gains of our savings and we would like to add another investment tool, which will grow for retirement. We are both 33 years old and have many years of savings ahead.
The variable annuity is one of the most flexible and underutilized financial instruments available. An annuity, first and foremost, is a contract between a life insurance company and an investor. There are two stages with an annuity: Stage one is the accumulation phase, during which the annuity compounds on a tax-deferred basis; and stage two is the income phase, during which the owner selects an array of income options, including outright withdrawals or traditional annuitization. If the income is due to annuitization, the income stream is partially tax-exempt as it constitutes a return of principal.
While there are many variable annuities (VAs) to select from and some will have special provisions, like a minimum initial investment, most will allow you to invest as much and as often as you'd like. With an initial investment of from $1,000 to $5,000, most VAs can be started with as little as $50 a month. Subsequent investments can also be as little as $50 a month.
A variable annuity offers a series of mutual fund type portfolios. Investment options typically include a diverse family of funds, several common stock accounts, a bond account, a fully managed account, and other equity accounts such as real estate and natural resources. In addition to these accounts, a VA may also offer a fixed account, similar in nature to a fixed annuity.
The owner can transfer money between these accounts as often as necessary and without income tax. Therein lies one of the significant benefits of a VA. While you are in the accumulation phase, making changes in your investment portfolio is most efficient if done within the confines of a tax-deferred account. This allows you to keep 100 percent of your gains working without creating any current tax liability (that is, capital gains).
Of course, if changes are being made due to underperformance (that is, losses), you are not allowed to take a corresponding deduction. However, if you are investing money in well managed equity accounts over longer periods of time, it is most likely that gains will be realized but not taxed.
So, if there is no tax while it grows and there is no tax when you make changes, when does it get taxed? It gets taxed when you spend it, and this is the income phase. Like an IRA, withdrawals from a VA are subject to a 10 percent penalty if taken before age 59-1/2 and are subject to ordinary income tax rates. Assuming you are over age 59-1/2 when you begin making withdrawals, 100 percent of the amount withdrawn is taxable (at ordinary income rates) until all the profits have been spent. Your principal investments are the last money to be withdrawn and therefore are not subject to income tax.
Withdrawals can be set up on a systematic basis, such as $200 per month; or taken in lump sum amounts as needed. These withdrawal options are in addition to a traditional "annuitization," which would be equal payments over a stated period of time. With traditional annuitization, a portion of each withdrawal would be a return of principal (your original investment) and not taxed. This flexibility can be useful when managing retirement cash flow.
At age 33, the tax-deferred growth over 27 years could be substantial. If you can live with the possible 10 percent penalty and considering you are maximizing all the other more important things - 401(k) and Roth IRAs - a VA may be a good fit for you. 
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