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What you need to know about fee-only annuities

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Annuities are one of those securities that elicit strong opinions. Love them or despise them, in certain situations they can be an important component of a client’s portfolio. Whatever your belief, the efficacy of annuities is not the subject of this post. Instead, we will focus on a little-known aspect of fee-only variable annuities and reveal how advisory fees can actually increase a client’s tax burden and expose them to an IRS penalty. 

Annuities: The Basics

An annuity is a product of an insurance company and may be immediate, deferred, fixed or variable. Annuities also contain risk. For example, in the event of an insurance company failure, because assets in a fixed annuity are part of the company’s general account, they are subject to the claims of creditors. Conversely, assets in a variable annuity are held in a separate account and do not contain this risk. 

For many years, variable annuities tended to have a high fee structure. This helped provide contractual guarantees for investors and a generous sales commission for the broker or advisor. The commissions were often so attractive that it enticed brokers to sell an annuity even when it was not in the best interest of the client.

This, plus the growth of the registered investment advisor channel, has helped to bring major changes in the annuity landscape. One of the most significant changes is the emergence of the fee-only annuity, which tends to have much lower internal fees and, as the name implies, does not pay a commission. These annuities have become a popular alternative for clients of some RIAs.

Fee-Only Annuities

There are a number of fee-only annuities available today. As mentioned, these annuities typically have very low internal fees and the advisor is paid a fee (i.e., a percentage of the account value) in lieu of a commission. However, in a non-qualified, fee-only annuity, the advisor’s fee deduction creates an income tax liability for the client. Here is an example to explain.

Let’s assume a client has a non-qualified variable annuity, that a 1.0 percent annual advisory fee is deducted from that annuity on a quarterly basis, that there are no other withdrawals, that the annuity’s market value is $100,000, and the client is age 50.

At tax time, the client will receive a 1099 with the total fee deducted (i.e., $1,000), which the client must claim as income on his tax return (Form 1040). However, because the client is also under age 59 ½, he will also have to pay a 10 percent premature withdrawal penalty on the $1,000. This only applies to non-qualified annuities where the advisory fee is deducted from the annuity. If the annuity is qualified, the fee deduction does not create a taxable event. However, if the client is under age 59 ½ an early withdrawal penalty will apply.

To remedy this, the advisor should deduct the fee from a different account. That said, be careful as the IRS will frown on the deduction if the annuity’s fee is taken from the client’s IRA. 


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