An investment-only variable annuity (IOVA) is a specialized type of annuity designed primarily for one purpose: investing. Unlike traditional annuities, which may provide lifetime income, an IOVA is primarily focused on growing your investment portfolio. Think of it as a tax-deferred investment account wrapped in an annuity structure. If you’re considering an IOVA, talk to a financial advisor about whether one aligns with your goals.
How an Investment-Only Variable Annuity Works
IOVAs, like other annuity contracts, are initially purchased from an insurance company or a financial institution. However, IOVAs are designed primarily as investment vehicles, not guaranteed streams of retirement income. Instead, they offer the potential for greater returns, but the income generated by IOVAs during retirement is dependent on how their underlying investments perform.
These annuities offer a wide range of investment options, such as stocks, bonds and mutual funds, allowing policyholders to create a diversified portfolio suited to their financial goals.
How IOVAs Are Taxed
Like other annuities, earnings within an IOVA grow tax-deferred until withdrawals are made. When you withdraw funds from your IOVA – whether as periodic payments or a lump sum – the gains are subject to ordinary income tax rates. This can be advantageous for individuals who expect to be in a lower tax bracket during retirement.
For example, if an investor’s tax rate falls from 32% to 24% when they retire, they’d end up paying fewer taxes on their IOVA withdrawals.
Similar to many retirement accounts, there’s a 10% penalty on withdrawals made before age 59½. However, there are exceptions to this penalty, such as disability or death.
Costs of an IOVA
There are a variety of fees associated with IOVAs, which can impact your returns. Here’s a look at four common charges and fees you could pay for an IOVA:
- Mortality and expense (M&E) fees: IOVAs typically charge M&E fees to cover the insurance aspect of the annuity. These fees can eat into your investment gains.
- Administrative fees: To manage your account and transactions, IOVAs impose administrative fees. These can vary among providers.
- Subaccount fees: IOVAs allow you to invest in subaccounts similar to mutual funds. Each subaccount may have its own management fees.
- Surrender charges: If you withdraw your funds before a specified period, you may face surrender charges. These can be steep if you withdraw early.
Benefits of Investment-Only Variable Annuities
These unique financial instruments offer several compelling benefits, especially for savers who max out their retirement account contributions and want to save even more on a tax-deferred basis. Here are four common benefits to consider:
- Tax-deferred growth: One of the primary advantages of IOVAs is their tax-deferred status. While your investments grow within the annuity, you won’t have to pay taxes on the gains until you withdraw the funds. This can provide a significant advantage, allowing your investments to potentially grow faster over time.
- Diverse investment options: IOVAs offer a wide range of investment options. This flexibility allows investors to tailor their portfolios to align with their risk tolerance and financial goals.
- Creditor protection: In many cases, IOVAs offer protection from creditors. This means that even in challenging financial situations, your investments held within the annuity may be shielded from potential legal claims.
- Guaranteed minimum death benefit: Some IOVAs come with a guaranteed minimum death benefit, ensuring that your heirs receive at least the amount you initially invested, even if market fluctuations have reduced the account’s value. Since annuities bypass the lengthy and costly probate process, IOVAs can allow for a seamless transfer of assets to beneficiaries.
Drawbacks of IOVAs
Alongside these benefits, IOVAs carry certain risks and disadvantages. It’s important to understand the potential drawbacks as your consider investing in an IOVA. Here are five common ones:
- Complexity: IOVAs can be difficult to understand, with intricate fee structures, subaccounts and investment options. Investors may find it challenging to grasp the full scope of these products, potentially leading to costly mistakes.
- Fees: As described above, IOVAs often come with a range of fees, including management, mortality and administrative expenses. These charges can eat into your returns and reduce the overall profitability of your investment.
- Lack of liquidity: IOVAs are long-term investments and accessing your funds can be restricted. Surrender charges, which can be substantial, may apply if you need to withdraw your money prematurely.
- Market risk: Since these annuities are tied to the performance of subaccounts invested in the market, they are susceptible to market fluctuations. This means that while there is potential for significant gains, there’s also the risk of substantial losses.
- Tax implications: While IOVAs offer tax-deferral benefits, withdrawals are generally taxed as ordinary income, potentially subjecting investors to higher tax rates.
What the “Free Look” Period Means for IOVAs
Variable annuities typically include a “free look,” a grace period that allows investors to evaluate an IOVA contract without commitment. This period generally lasts for a set number of days, usually 10 to 30, depending on the insurance company and state regulations. During this time, investors can review the terms and conditions of the IOVA contract, the investment options available and the associated fees.
Envision a scenario in which you have just purchased an IOVA but start having second thoughts. This is where the free look period proves advantageous, allowing you to cancel the contract without penalty. During this limited time, you’d have the opportunity to reassess your decision and take a second look at whether it aligns with your financial goals.
Investment-only variable annuities (IOVAs) can be a valuable addition to your investment portfolio, offering tax advantages, diversification and a means to supplement your retirement savings. However, IOVAs differ from other annuities in that they do not generate guaranteed lifetime income. Also keep in mind they have various fees and other expenses that could depress your returns.
Retirement Planning Tips
- If you’re unsure how much you need to save to afford retirement, give SmartAsset’s retirement calculator a try. The free tool will estimate how much you need to have to meet your expenses in retirement and whether you’re on track.
- Retirement planning can be complicated but a financial advisor can guide you through the process. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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