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Life Health > Annuities

The New Tax Law and Annuities

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Every time there is a significant change in tax law, the first question those of us in the insurance business ask is ‘what does this mean to annuities?’

The short answer, in the case of recent legislation, is that as significant as it is for our economy, it really isnt particularly significant for annuities. Its important to note that the legislation certainly didnt do anything to help annuities, but it didnt hurt them much either. Heres why.

As it relates to annuities, the relevant parts of the new tax law are the cuts in capital gain tax rates and the cuts in dividend tax rates. For many annuity buyers, this results in tax rates for dividends and capital gains at the 15% level. This is contrasted to annuity distribution tax rates at a level of ordinary income, which now stands at a maximum of 35%. The obvious consequence is to increase the break-even holding time for VAs. This is the time necessary to allow the tax-deferred attributes of annuities to become sufficiently positive to overcome the lower tax rate of a mutual fund. But theres more to it than that; first, lets narrow the argument.

This isnt simply a comparison of all annuities to mutual funds. Fixed annuities arent particularly affected by capital gains or dividend tax rates due to the fact that the alternative to fixed annuities is usually not equity mutual funds. Instead they are normally compared to other relatively safe investments. Its probably worth noting that some bond funds (usually considered pretty safe) may be an alternative to fixed annuities, and that gains attributed to bond funds held longer than a year may have the capital gain advantage. But this is a relatively small issue when viewed in context of all the available fixed annuity alternatives. Next we note that the tax law change is irrelevant as it relates to qualified annuities. In other words, the changes apply to neither qualified plans inside annuities nor outside annuities.

Therefore when you consider that qualified annuities, roughly 40% of the market, and fixed annuities, roughly 50% of the market, according to LIMRA and VARDS, are not substantially impacted by this tax law change, this leaves only 30% of the annuity market to be impacted. Of this 30%, I would expect that the new tax law would influence only about 20% of these potential buyers. Consequently, I believe that the impact of the new tax law on annuities will be less than 10%. Heres why.

Many variable annuity buyers are attracted to the product, not for tax deferral, but instead for death benefits and living benefits. Particularly attractive to investors today are principal guarantees that emphasize return of the money instead of return on the money. Its also interesting to note that in many surveys conducted over the years, according to NFC Consulting Group, tax deferral has never been listed as the top reason for buying non-qualified annuities, but instead it has usually been safety or security. It is not that tax deferral isnt important, but it has usually been second or third on the list. These surveys and other evidence point to the fact that annuity buyers are quite safety conscious. They are particularly interested in the guarantees inherent in the annuity products.

Another reason that this legislation may not have a huge impact on annuities is due to the sunset provisions. The dividend tax rate reduction and the capital gains tax rate reduction are scheduled to end in 2008. There are a variety of opinions on whether these provisions will sunset, and if so, when. But even if the majority of buyers believe the sunset provisions will be eliminated, theres enough doubt and uncertainty to keep buyers engaged in the annuity story, since it is truly a long-term retirement planning story that may span many sunset provisions.

Last, but not least, lets assume the provision doesnt sunset and your clients have substantial wealth in non-qualified deferred variable annuities. There are some things you may want to consider for your clients to maximize their annuity growth relative to taxable accounts. For example, consider repositioning stock funds with higher turnover inside the annuity. Funds that tend to pay high dividends, that are really interest payments and therefore not eligible for the dividend rate reduction (e.g. bonds, high yield bonds), may also be better held inside the annuity. Keep in mind that any of these options need to be evaluated in connection with your particular clients circumstance, including risk tolerance, suitability, and present and future tax considerations.

If you are able to become a real asset to your clients by understanding the new legislation, responding appropriately given their particular circumstances and repositioning assets as appropriate, theyll have a better retirement, and so will you.

Thomas Streiff, CFP, CLU, ChFC, CFS, is director of investment solutions at UBS PaineWebber, responsible for the separate accounts, mutual funds, insurance and annuity product areas. He can be reached via e-mail at [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, July 21, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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