Investment-only variable annuities (IOVA) have surged in popularity in recent years as an alternative tax-advantaged investment vehicle. This comprehensive guide will explain everything you need to know about IOVAs – how they work, pros and cons, key considerations, and whether they should be part of your retirement portfolio.
Introduction – Investment-Only Variable Annuity(IOVA)
An IOVA is a type of annuity contract that isolates the investment features while eliminating traditional annuity guarantees. IOVAs offer tax-deferred growth on a diverse selection of investment subaccounts. They provide greater control over assets compared to traditional annuities with complex living and death benefit riders.
As Americans live longer lifespans and face rising healthcare costs, the appeal of IOVAs for retirement planning has grown. They offer retirees more flexibility to address changing needs late in life. However, IOVAs have some risks that make them unsuitable for conservative investors. Carefully weighing the tradeoffs is key before adding an IOVA to your portfolio.
Understanding Annuities
Annuities are insurance contracts designed to provide guaranteed lifetime income in retirement. The two main types are fixed and variable annuities:
- Fixed annuities offer a preset, guaranteed rate of return. The principal and earnings are protected from market swings.
- Variable annuities allow you to invest in market subaccounts with the potential for higher returns but also greater risk compared to fixed annuities.
Annuities commonly include living and death benefits that guarantee income or account value protections. These riders provide safety but reduce investment flexibility. Annuities also have complex fees that can erode long-term performance.
Investment-Only Variable Annuity Defined
An IOVA isolates the investment features of a variable annuity while eliminating the insurance guarantees and riders. Key aspects include:
- Access to a wide range of investment subaccounts across stocks, bonds, mutual funds, and other asset classes.
- Tax-deferred growth potential since earnings are not taxed until withdrawn.
- Available as non-qualified or qualified within an IRA or other tax-advantaged account.
- No death benefit, income rider, or other insurance protections. You assume full investment risk.
- Typically lower annual fees than traditional variable annuities with complex guarantees.
IOVAs appeal to savvy investors comfortable with higher risk for higher potential returns. Those seeking protected income or downside protection may prefer traditional variable annuities.
How an Investment-Only Annuity Works
An IOVA functions similarly to a variable annuity in providing a menu of investment options but strips out the guarantees:
- Subaccount investments – IOVAs provide exposure to stocks, bonds, mutual funds, ETFs, and alternatives. The extensive menu allows customized allocation.
- Tax-deferred growth – No taxes are owed on interest, dividends, or capital gains until funds are withdrawn. This turbocharges compounding versus taxable accounts.
- Liquidity – Most IOVAs allow penalty-free withdrawals up to 10% annually. However, withdrawals before age 59 1⁄2 face ordinary income taxes plus a 10% IRS penalty.
- Low fees – Annual IOVA costs are typically 1-2% compared to over 3% for many variable annuities with riders. Lower expenses support growth.
- Institutional funds access – Many IOVAs provide access to institutional share classes and alternative investments not available in 401(k)s or IRAs.
Tax Advantages of IOVAs
A key benefit of IOVAs is their tax-deferred status allowing gains to compound tax-free. This contrasts with taxable brokerage accounts where taxes must be paid annually on dividends, interest, and capital gains.
Upon withdrawal from an IOVA, income is taxed as ordinary income. This is a higher rate than the 15-20% capital gains rate in taxable accounts. Required minimum distributions from an IOVA must begin at age 72.
If structured as a non-qualified annuity, IOVAs allow tax-efficient lifetime income via the exclusion ratio. Part of each payment is considered tax-free return of principal.
Costs and Fees
IOVAs incur the following annual expenses:
- Mortality expense – Cost of the life insurance component, averaging ~1.25%.
- Administrative fees – Covers recordkeeping and other operational costs, typically 0.15-0.25%.
- Investment management fees – Expenses of the underlying funds, similar to mutual fund expense ratios.
- Optional riders – Features like stepped-up death benefits available for added fees.
The total annual IOVA cost averages 1-2% based on the provider and investments selected. This is lower than traditional variable annuity fees of over 3% once riders are included. Still, expenses compound over time so minimizing costs is key.
Drawbacks and Risks
While IOVAs provide greater control and access to alternative investments, they have notable downsides:
- No guarantees – Unlike traditional variable annuities, IOVAs offer no lifetime income or death benefit protections. Your account value depends solely on investment performance.
- Higher tax rate – Ordinary income tax rates up to 37% apply to IOVA withdrawals rather than the 15-20% capital gains rate.
- Loss of tax deferral – Withdrawing funds before age 59 1⁄2 results in a 10% IRS penalty along with ordinary income taxes.
- Lack of insured protection – Traditional annuities are backed by state guaranty associations up to $250,000. IOVAs lack this safety net if the insurer fails.
- Higher risk – Those nearing retirement may not have time to recover from market downturns. Traditional annuities with income riders reduce this risk.
“Free Look” Period
IOVAs provide a 10-30 day window after purchase where you can terminate the contract and get a full refund. This “free look” period allows you to carefully review the IOVA features, investment options, fees, and determine if it aligns with your planning needs. Be sure to consult a tax advisor during the free look period.
How IOVAs Compare to Other Investment Vehicles
Mutual Funds/ETFs – Compared to mutual funds and ETFs, IOVAs provide access to institutional share classes and alternative investments not available elsewhere. The tax-deferral can substantially boost long-term gains. However, the annual fees are higher.
Traditional Annuities – Traditional variable annuities limit investment flexibility but offer guaranteed lifetime income and death benefits. For conservative investors, traditional annuities reduce risk close to retirement. But the complex guarantees result in higher annual fees.
401(k)s/IRAs – IOVAs offer similar tax-advantages to 401(k)s and IRAs with higher contribution limits. 401(k)s have creditor protection but limited investment options. IRAs provide more flexibility but lack 401(k) loan provisions.
Real-World Case Studies
John, 68 – Shifted $500,000 from his taxable brokerage account into an IOVA. He utilizes the tax-deferral benefit to invest aggressively in stocks he’d otherwise need to limit for tax efficiency.
Mary, 52 – Redirected a portion of her 401(k) contributions into an IOVA for exposure to institutional hedge funds and commodities futures not available in her employer plan. She uses the IOVA as a satellite holding around her core portfolio.
John and Jane – Roll over $200,000 from a traditional annuity with an income rider into an IOVA. They appreciate the greater liquidity and investment flexibility as their priorities change later in retirement.
Choosing the Right IOVA
Here are key factors to evaluate when selecting an IOVA provider:
- Investment options – Look for a diverse menu of stocks, bonds, mutual funds, institutional classes, and alternative asset access.
- Fees – Compare total annual costs across providers. Lower expenses support better net returns.
- Financial strength – Choose an issuer with strong credit ratings from AM Best, Moody’s, and S&P. This ensures their ability to manage the contract.
- Transparency – Select a provider that discloses all fees, terms, and investment details up front.
- Customer service – Gauge responsiveness and expertise by contacting customer service before investing.
An experienced financial advisor or annuity specialist can help identify a top IOVA issuer suited to your specific needs and objectives.
Conclusion
In summary, IOVAs offer a way to invest retirement savings in a tax-advantaged vehicle without traditional annuity guarantees. The extensive investment options and tax deferral can significantly boost long-term returns for savvy investors comfortable with market risk. However, IOVAs carry more risk than traditional annuities with guaranteed income. Conduct thorough due diligence and work with a trusted advisor to determine if adding an IOVA aligns with your financial plan.
Frequently Asked Questions
What is the minimum investment for an IOVA?
Most IOVAs have minimum investments of $10,000 – $25,000. Some providers allow lower initial contributions for qualified IOVAs within an IRA.
Can you access funds before retirement with an IOVA?
Yes, most IOVAs allow penalty-free withdrawals up to 10% annually. However, withdrawals before age 59 1⁄2 face a 10% IRS penalty plus ordinary income taxes.
What are the tax implications for IOVA heirs?
Non-spouse beneficiaries must take full distribution within 5 years. They lose the option to stretch tax-deferred growth over life expectancy available with inherited IRAs.
How do market downturns impact IOVAs?
Unlike traditional annuities, IOVAs provide no guarantees against market risk. However, the diverse investment options allow tactical allocation to mitigate volatility.
What surrender charges apply if exiting an IOVA early?
Most IOVAs do not impose surrender charges. However, a few providers may assess declining penalties over 3-7 years if the contract is terminated early.
Can you convert an IOVA to a traditional annuity with lifetime income?
Yes, most IOVA providers allow converting to a traditional annuity with guaranteed income. This provides options to reduce risk later in retirement.
Are there any age limits for purchasing an IOVA?
No, there are typically no maximum age restrictions. As long as you meet the minimum investment requirements, you can utilize an IOVA at any age.
How are IOVAs regulated?
IOVAs are regulated at the state level by insurance commissioners. Reputable providers adhere to stringent standards to protect investors.
Can you name beneficiaries on an IOVA contract?
Yes, IOVAs allow you to name beneficiaries who may choose to continue the tax-deferred status after your death by establishing an inherited IOVA.