Retirement goals, investable assets and tax circumstances are unique to every client. Yet clients generally have one goal in common: They want more retirement savings from their invested dollar. For many clients, this may be what attracts them to a variable annuity.
An annuity’s built-in tax deferral may help clients accumulate more per dollar invested (as compared with a taxable investment). In fact, tax deferral may be as important to some investors as guarantees. According to the Committee of Annuity Insurers’ “2013 Survey of Owners of Individual Annuity Contracts,” 86 percent of policyholders cited tax deferral as an important reason for buying an annuity, while 81 percent said guaranteed lifetime payments were an important consideration.
Awareness of asset placement is critical to making the most of a variable annuity’s tax deferral advantage: Asset classes that may be more likely to generate high levels of taxable income may be more appropriate within a variable annuity, while more tax-efficient assets might be better placed in taxable accounts.
Identify the Prime Candidates
When it comes to tax efficiency of investments, asset class and investment style generally will trump all else.
Taylor Larimore, a retired chief of the Small Business Administration’s finance division and a former IRS officer, ranks asset classes by tax efficiency, from least efficient (top of the following list) to most efficient (bottom of the list). Here is his list:
» High-yield bonds
» Taxable bonds
» Real estate investment trusts
» Small-cap stocks
» Large-cap stocks
» International stocks
» EE and I bonds
» Tax-exempt bonds
Morningstar’s mutual fund tax-cost ratios give a general sense of the relative tax efficiency of these asset classes. These tax-cost ratios measure how much a fund’s annualized return is reduced by the taxes investors pay on distributions, including ordinary income tax, short-term capital gain tax and long-term capital gain tax. Morningstar assumes ordinary income tax liabilities based on the top federal income tax bracket and top long-term capital gain tax rate for each year (e.g., 39.6 percent income tax rate and 20 percent long-term capital gain tax rate in 2014).
To put the impact of these tax costs into perspective, compare the average before- and after-tax three-year returns for high-yield bonds, the least efficient asset class in the list above. The average high-yield bond fund tracked by Morningstar returned 7.41 percent before taxes in the three years ended Jan. 2, 2015. Subtracting the average three-year tax-cost ratio cuts the return, after taxes, by one-third, to 4.92 percent. This is a strong argument for holding these investments within a variable annuity to minimize the tax bite.
The same could be said of real estate investment trusts (REITs). Dividends represent a large portion of returns from the asset class, but in most cases, REIT dividends are taxed at the client’s ordinary income tax rate, up to 39.6 percent. On top of this, married clients with modified adjusted gross income above $250,000 ($200,000 for singles) are subject to an additional 3.8 percent tax on their net investment income, whether from ordinary income or from capital gains.
Given the present low-yield environment, some investors may opt for REITs and high-yield bonds over less volatile fixed-income investments. They can be a source of potentially greater yields
while providing an additional measure of portfolio diversification, since both have a modestly low correlation with the core stock and bond asset classes. But the tax inefficiency of these asset classes may outweigh the benefits of yield and diversification.
Clients could rein in current tax liabilities on various asset classes by investing in less actively traded funds such as index or exchange-traded funds (ETFs). However, this may not be an ideal solution for some clients. While limiting the client’s exposure to the capital gains generated by actively traded mutual funds, index funds and ETFs do not prevent the distribution of, or change the character of, dividends. For example, in most cases, REIT dividends still will be taxable at ordinary income tax rates, and large-cap stocks will still put forth taxable dividends. The three-year tax efficiency of large-cap index funds tracked by Morningstar ranged from 0.17 percent to 3.51 percent. The majority carried tax-cost ratios between 0.50 percent and 1.25 percent, according to Morningstar Premium Fund Screener data. The lesser-traded index funds resulted in a relatively modest savings over the average three-year tax-cost ratio of 1.44 percent for actively traded large-cap funds.
For many clients, buying and selling fund shares increasingly creates another layer of tax costs. More aware of risk in the wake of the financial crisis, clients may be demanding tactical investment strategies that trade portfolio positions more frequently as market and economic conditions change. With increased trading comes the potential for more taxable events.
Contemporary variable annuities may stave off the tax costs of tax-inefficient asset classes. Modifications to variable annuities in recent years are designed to decrease basic annuity and separate account expenses and expand investment options. Hundreds of investment options including alternative asset classes, combined with low-cost or free exchanges between subaccounts, make broad diversification and tactical trading possible without triggering current tax obligations. Assets can be positioned where they make sense and minimize current tax liability. In this way, you can help your client make the most of tax deferral while maintaining the ability to alter the investment mix as needed.
Now that the Federal Reserve has ended its bond-buying program and U.S. economic growth is accelerating, higher interest rates are in the offing. As a result, many clients are thinking about reallocating their portfolios in order to leverage those trends. This may be an opportune time to introduce a variable annuity to their retirement savings portfolio, which may help maintain their ability to reallocate their assets while positioning them for maximum tax savings.