Indexed Annuities

Most, if not all, Equity Index Annuities today guarantee your principal, lock in gains from previous years, and provide a guaranteed minimum annual rate of return (usually 2-3%) on that total. During a year of growth, EIA owners participate in a portion, typically 55 to 80%, of those gains via linkage to the published returns of the various equity indices (the S&P 500, NASDAQ 100, DJIA, Russell 2000, etc.). During a subsequent down year, an EIA owner’s principal and accumulated gains are “locked in” and carried forward (also known as “annual reset”) to their next contract anniversary. If the markets should recover the following year, the EIA owner would again participate in a portion of those gains without having to climb out of the previous year’s correction. Mutual funds do not provide the same benefit, and an investor can lose substantial portions of his principal and past gains during a market downturn.

Simply put, this means that you benefit from “triple compounding”: You earn interest on your principal, you earn interest on your interest, and you earn interest on the money you would otherwise have paid in taxes on both. If your annuity came with a first-year premium bonus, you would have benefited from quadruple compounding, having earned interest on that bonus as well. Mutual fund gains are annually reportable and taxable, thus denying an investor the benefits of such three-fold compounding.

Many indexed annuities offer a premium bonus in the first year, ranging from 4 to 11% of the original premium contributed. Some companies even continue this for additional premium deposits over the next 1-5 years. Mutual funds do not offer similar bonuses.

Equity Index Annuities grow tax-deferred until interest is withdrawn, thus allowing their owners to control precisely when and how much money will be taxable to them, depending upon their needs and circumstances from one year to the next. Mutual fund owners are subject to the fund manager’s annual capital gains distributions whether or not they redeem any shares for additional income. Many equity funds have turnover rates averaging over 80% annually, meaning that management sells over 80% of their fund’s holdings yearly, replacing them with other stocks (and sometimes even repurchasing the same stocks after January 1st), often to beat their category averages. Because of this, mutual funds rarely provide the 20% long-term capital gains tax rate that many claim their owners might receive. The reportable gains that a mutual fund shareholder must pay taxes on each year are exclusively a function of how long the fund manager holds the underlying investments they purchase and have almost nothing to do with how long the shareholder has owned their fund.

Mutual funds not only require income reporting (and the resulting annual taxation) when the mutual fund is going up in value but can also impose income taxes in a year when the fund has gone down in value. When the markets take an extended downturn after several years of sustained growth (as they did in 2000-2002), fund managers will often resort to selling appreciated stocks purchased several years earlier to generate gains to offset those losses. This minimizes the fund’s published loss-in-value at year-end, allowing the fund to claim that it was “only” down, say, 9% on the year while its peer group was down an average of perhaps 17%. The unsuspecting shareholder of this fund receives his December 31st statement, sees his account is down 9%, and assumes incorrectly that “at least” he’ll owe no taxes on his “loss” come April 15th. Three weeks later, he received a Form 1099-Div from his mutual fund company showing several thousand dollars of reportable income. The reason for this is that the longer-held stocks that the fund manager sold to reduce his fund’s year-end loss were sold at a gain (over their original purchase price years earlier), a gain that is now reportable and taxable to the mutual fund owner even though his statement shows his account balance is down. Equity Index Annuities grow tax-deferred, cannot lose value in a market downturn, and impose no annual tax reporting as the annuity increases.

The ownership of mutual funds may require the mutual fund owner to pay estimated taxes. Tax-deferred accumulation inside an Equity Index Annuity does not create the same tax problem. Equity Index Annuities are easy to position so that, at the owner’s death, the annuity will not be subject to either estate or income taxes. The same tax reduction techniques do not work nearly as well with mutual funds. There are numerous, often costly, tax traps associated with the timed buying and selling of mutual fund shares, traps that do not apply to Equity Index Annuities.

Additionally, mutual fund ownership can result in the loss of tax exemptions, tax deductions, and tax credits, and mutual funds (except those held in an IRA) are usually subject to state and local income taxes in those states that have such taxes. These losses do not occur with Equity Index Annuities, and because they grow tax-deferred, EIAs are not subject to state and local income taxes during their accumulation phase. Finally, mutual fund ownership, specifically the annual distributions made by such mutual funds, can subject the fund owner to taxation under the Alternative Minimum Tax (AMT). The AMT always results in increased income taxes. Equity Index Annuity ownership cannot trigger the AMT in the same manner as mutual funds.