How Investment-Only Annuities Can Help Clients Save on Taxes

President Laurence Greenberg of Jefferson Financial talks to ThinkAdvisor about the low-cost investment-only variable annuities his firm pioneered

Jefferson National President Laurence Greenberg. Jefferson National President Laurence Greenberg.

Variable annuities became lots more loveable to RIAs and their clients when Jefferson National pioneered the low-cost investment-only variable annuity (IOVA) seven years ago. Tax deferral is a key attraction, as well as the contract’s flat $20-a-month fee. As with other VAs, income earned won’t be taxed until the funds are withdrawn.

Now, with a growing number of companies offering IOVAs, the space is the fastest growing segment in the VA arena, according to many industry members.

IOVAs allow clients to invest in a wide range of actively managed funds. Some IOVAs may be available with the guarantee of a death benefit, same as traditional VAs – or else it is offered as an added option.

Drawbacks include a 10% penalty payable to the IRS if funds are withdrawn before the client reaches age 59 1/2, as well as market risk, especially when investing in alternatives among the IOVA’s underlying funds.

Jefferson, now Nationwide Financial’s advisory solutions business, based in Louisville, Kentucky, boasts 4,200-plus advisors – RIAs and hybrid BD reps – using its IOVA, dubbed Monument Advisor. Assets under management in the no-commission, no-surrender-fee annuity total $4 billion. The firm serves up a wide range of tax-deferred IOVA funds, including fixed income and REITs – similar to those that advisors use in taxable accounts.

ThinkAdvisor recently interviewed Jefferson's president, Laurence Greenberg, about the considerable tax efficiencies of investment-only variable annuities. Greenberg led the firm’s Monument Advisor launch, the first flat-fee IOVA. Here are excerpts from our conversation:

THINKADVISOR: Why is a variable annuity a good choice for income tax mitigation?

LAURENCE GREENBERG: One of its prime components is that the money grows tax-deferred. But for a long time, the value of helping people save tax-deferred and then annuitizing an income stream was overshadowed by living benefit riders.

What’s the salient tax-related issue about an investment-only variable annuity (IOVA)?

The accumulation phase is tax deferred. This is important because advisors who manage money believe that they’re able to manage market risk over a long period. So they’re looking for ways to improve accumulation. A key part [of an IOVA] is having the right variety of funds but also making sure that the cost of the tax-deferral benefit is extremely low.

What’s a downside to using an annuity as a tax-efficient strategy?

Just like with an IRA accunt or a 401(k), the IRS can assess a 10% penalty if you withdraw the funds before age 59 1/2.

Can IOVAs be rebalanced without generating a tax liability?

Absolutely, because the money is growing tax deferred. An advisor may decide to put investments that take losses in a brokerage account so that the client can get a tax benefit, but where there are investment gains, in an [IOVA] since there won’t be an immediate tax implication.

What asset classes are available, and how can these reduce taxes?

With an IOVA’s tax-deferral benefit, you can invest in tax-inefficient asset classes like fixed income and alternatives without paying ordinary income or short-term gains taxes. It isn’t any different from managing money in an IRA. You leverage the IRA for gains because it’s tax-deferred and harvest losses within the taxable accounts.

Is an IOVA appropriate for use in a trust?

Yes because once a trust generates income of roughly $12,000, it’s taxed at the highest ordinary income rates. But with an investment-only variable annuity within a trust, that income is protected; and you can accumulate it tax-deferred long term. 

What’s the main issue an advisor should consider when recommending a variable annuity?

The client’s overall goal and using a [VA] to address a part of the portfolio where it makes the most sense. When building a portfolio, it’s very important to think about those allocations that are tax inefficient vs. tax efficient. To get the benefits of tax deferral, you would locate an IOVA in asset classes that are already [throwing off] ordinary income, such as fixed income, or in portfolios that are generating short-term capital gains. Upon withdrawal, annuity income is taxed as ordinary income.

What else should be examined?

The client’s liquidity needs. How much money will they need? Or would the money be in the annuity for the long term so that a liquidity need doesn’t exist?

What about withdrawal strategies?

[IOVAs] provide flexibility. An advisor would max out the client’s tax-deferred retirement plans like IRAs and 401(k)s and then put the excess [assets] into a nonqualified account [like an IOVA] that’s growing tax-deferred. Because it’s after-tax money, any nonqualified account isn’t subject to required distribution. That means you can better plan how to take distributions in specific years later in the client’s life.

Has the IOVA quashed any investor-perceived negatives about annuities?

Yes, because it reframes the annuity. For example, our Monument Advisor is very low cost and since we’re not paying advisors a commission, we have no surrender fee: If the client withdraws their money, we don’t assess a charge.

What’s the future of annuities?

With baby boomers, in particular — many are still accumulating — who need retirement income, advisors will use annuities for specific purposes within a portfolio. They’ll use them increasingly as a part of a holistic portfolio to manage accumulation and then the generation of income. With the movement to fee-based in qualified accounts, you’re going to see more use not only of annuities but other products that are built for the fee-based model.

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