Take-Away: A variable annuity is an investment tool that is sometimes used to defer income recognition with regard to grow wealth, but it carries some unique income tax ‘attributes’ [that’s putting it mildly] that often make it an unattractive investment strategy. If an individual is considering the the purchase of a variable annuity, he/she might first look at the use of an IRC 529 account as an alternate investment strategy used to accumulate wealth and avoid immediate income taxation, even though 529 accounts are not supposed to be used ‘investment’ vehicles.

Background:  A 529 account should primarily be considered as a tax-incented way to pay for college and graduate school, as its earnings, if devoted to those expenses, are income tax-free. But if an individual looks to accumulate wealth on an income tax deferred basis, a 529 account, despite some of its own inherent income tax drawbacks, might still provide more benefits and protection than the purchase of an income tax deferred variable annuity, or so a recent article from Alan S. Gassman suggests.

Comparisons: Some of the factors to consider if a 529 account is looked at as an alternative investment strategy compared to a variable annuity follow:

  1. Taxation:
    • Annuity-With a variable annuity, unlike a life insurance contract, the first dollar’s withdrawn from the annuity are treated and taxed as taxable income. Only after all of the income is withdrawn by the annuity owner, and taxed, will the cost basis in the annuity contract then be returned to the owner income tax-free. While a variable annuity can be exchanged tax-free under IRC 1035, it might take up to 18 months, post-exchange, before a withdrawal can be taken from the ‘new’ variable annuity. Example: $80,000 is invested in a variable annuity, which is now worth $100,000. A withdrawal of 20%, or $20,000, is taken. The annuity owner must pay an income tax on the full $20,000; if the owner is at the 40.8% income tax bracket [$37% federal + 3.8% NIIT] the income tax paid on the $20,000 withdrawal would be $8,160.00.
    • 529- The money that is withdrawn from a 529 account is taxable, pro rata, on the income portion. Example: $80,000 is invested in a 529 account, which grows to $100,000 in value.  A withdrawal of $20,000 from the 529 account results in an income tax on only $4,000 at the owner’s highest income tax bracket, which results in a federal income tax of $1,632, plus the additional 10% excise tax ($400) since the withdrawn income funds were not used for higher education purposes. That excise tax of $400, when added to the $1,632 in federal income tax, results in a combined income tax of $2,232 on the $20,000 distribution from the 529 account. Moreover, if the income generated by the 529 account is used for higher education and related expenses, there will be no income taxation of that income generated in the 529 account.
  1. Payouts:
    • Annuity- Variable annuities have to be paid out within 5 years of the death of the annuity holder, or possibly longer over the life expectancy of the named beneficiary of the annuity [an exception being the owner’s surviving spouse if he/she is the named beneficiary of the variable annuity.]
    • 529- There is no distribution requirement on the death of the owner of the 529 account. The ownership of a 529 account can pass from person to person, and from one generation to the next, without taxation.
  1. Trust Ownership:
    • Annuity- Unlike a life insurance policy, a variable annuity cannot be owned by a non-grantor trust unless the trust instrument contains unique provisions that expressly make it clear that the annuity is held in the trust for the benefit of an identified individual. On the death of the variable annuity owner the policy ownership or contract rights that pass to an irrevocable trust to be held for a surviving spouse or the annuity owner’s descendants will probably have to be paid out within 5 years of the annuity owner’s death, leading to a ‘bunching’ of the annuity’s taxable income to the trust in a relatively short period of time, potentially taxed at marginally higher income tax rates, e.g. 37% +3.8%. While these high tax rates can be mitigated by trust distributions of the taxable income to trust beneficiaries who are in lower marginal income tax brackets, those ‘forced’ distributions in order to save income taxes may be inconsistent with the settlor’s wishes. Note, too, that while some trusts attempt to emulate the use of see-through distributions of a variable annuity, much like an IRA that is made payable to an irrevocable trust, the IRS has failed to publish regulations to provide any ‘safe harbor’ leading to the conclusion that probably the variable annuity that is paid to an irrevocable trust will be paid out within 5 years.
    • 529- A 529 account can be owned by a complex trust, FLP or FLLC, without any mandatory payout rules.
  1. Transfers:
    • Annuity- The income accumulated in a variable annuity is usually triggered on the transfer of ownership of the policy. Restated, if the owner of the variable annuity wishes to make a gift of the variable annuity, he/she is considered to have received all of the income ‘inside’ the annuity contract at the time of the annuity transfer. If the variable annuity owner is not age 59 ½ at the time of the policy transfer, or the annuity owner is not an individual, then the ‘inside’ accumulated income will be taxed at the owner’s highest marginal income tax bracket plus the additional 10% penalty for the ‘early deemed withdrawal.’
    • 529- The ownership of a 529 account is freely transferred without triggering any income taxation [gift taxes yes, but not income taxes.]
  1. Gift Taxes:
    • Annuity- A gift that is used to purchase a variable annuity will be considered to have been made 100% in the year of purchase of the annuity.
    • 529- A individual who wishes to make gifts to a 529 account can elect to have 80% of the amount transferred considered to have been gifted in the four following calendar years after the 529 is funded in order to maximize the use of the donor’s $15,000 per year per donee annual exclusion gift opportunity. Example: Grandparent transfers $75,000 to grandchild’s 529 account in one year, in a lump sum deposit. That gift will be treated as the year-of-gift transfer of $15,000 [the gift tax annual exclusion amount] and will be deemed the grandparent’s annual exclusion gift to the same 529 account for each of the next four calendar years. If the grandparent dies before the 5th year after the 529 account was funded, then a portion of the 529 account will be treated as being owned by the grandparent for federal estate tax calculation purposes.
  1. Savings Bonds:
    • Annuity- The accumulated interest earned on Series EE and Series I U.S. Savings Bonds, purchased after 1989, will be taxed if the bonds are surrendered and the net proceeds used to purchase a variable annuity.
    • 529- The accumulated interest earned on these Savings Bonds can be rolled over directly into a 529 account and the income tax on the accumulated interest will be deferred until the 529 funds are withdrawn for other than higher education purposes. [Note that this rollover to the 529 account opportunity is only available to single taxpayers with an adjusted gross income (AGI) of less than $93,150 or married taxpayers with an AGI of less than $147,250.]
  1. Creditor Protection:
    • Annuity- Annuities can be protected under Michigan statute, but that statute is well over 60+ years old and the creditor protection is somewhat buried. Moreover, it is not abundantly clear that all annuities, like a variable annuity, are completely protected from creditor claims under this old-time statute. MCL 500.2207(1) addresses the right of a ‘husband to insure his life for the benefit of his wife’ and for ‘any father to insure his life for the benefit of his children’…”free from all claims of the representatives of such husband or father, or any of his creditors.” MCL 500.2207(2) starts: “If a policy of insurance or contract of annuity is effected by any person on his own life or on another life in favor of a person other than himself “the lawful beneficiary of assignee thereof (other than the insured or the person so effecting such insurance or his executors or administrators) shall be entitled to the proceeds and avails (including cash surrender value thereof) against creditors and representatives of the insured and the person effecting the same. A couple of court cases in the past 20+ years have held that policy cash surrender values are not protected from creditor claims despite these creditor protection statutes. As such, it is questionable if a variable annuity can be completely protected from the annuitant-owner’s judgment creditors. A few states will not provide any creditor protection to annuities, either regular or the variable version.
    • 529- A 529 account in Michigan, along with an account in a qualified tuition program or educational saving trust under IRC 529 or IRC 530 is exempt from creditor claims. [MCL 600.6023(1)((l)(iii).]  Also a trust, fund or advance tuition payment contract established under the Michigan Education Trust Act [MCL 390.1421 to 390.1442] and an account established under the Michigan Education Savings Program Act [MCL 390.1471 to MCL 390.1486] are also exempt from creditor claims. [MCL 600.6023(l)(i)(ii).]
  1. Costs and Charges:
    • Annuity- The Vanguard variable annuity, invested in a growth fund, will cost approximately 0.67% per year, using it as a common benchmark product. If an investor purchases a variable annuity from a bank or broker, there will also be sales commission to pay. The median total annual costs for a variable annuity with a front-end load commission is about 1.67% per year.
    • 529- The Vanguard 529 Plan invested in a growth fund has an average annual expense of 0.15%. The median total annual costs for a 529 account with a front-end load commission is about 1.14% per year.
  1. Investment Amount:
    • Annuity- There is no limit as to the amount an investor may invest in a variable annuity.
    • 529- 529 Plans do have limits on the amount of cash that can be contributed on behalf of each designated beneficiary to each 529 account, which amounts vary from state to state, but are usually tied to the estimated amount necessary to finance the designated beneficiary’s education expenses. As an example, the 529 Plan offered through Vanguard imposes a contribution limit of $370,000.

Conclusion: 529 plans and their favorable tax attributes are designed to incent individuals to save for higher education expenses, and not as a conventional tax-deferred investment vehicle. That said, some 529 beneficiaries never incur higher education expenses, which means that, by default, the funds that were set aside in the 529 account will never be used to pay those expenses, which results in the 529 account just becoming another mechanism to hold and accumulate wealth. This is just one more way to ‘look outside the box.’