For Future Tax Flexibility, Consider a Variable Annuity

As the market headed toward the 11th anniversary of the bull market, many advisors found themselves with a dilemma: How do you reduce client equity exposure without incurring substantial capital gains? Do you just bite the bullet by selling equities and moving the proceeds into a more conservative asset class, or do you just hold tight and hope the market doesn't solve some of the problem for you?

For those of you who elected to sell and incur the taxes, I'm sure you and your clients are glad you did. For those of you who elected to ride it out, I'm sure you are now hoping the market soon recovers. In the interim, let me suggest a proactive step that you can take to help avoid this situation again in the future.

Now that your clients' unrecognized taxes have been significantly reduced, consider moving some of those assets into a variable annuity — not because of the lifetime income it can provide, but because of the tax flexibility it offers.

Let's consider two hypothetical clients. Both have $500,000 that they now have moved to the sidelines due to recent market volatility. At some point in time, you are going to suggest that they take advantage of these lower stock prices and move some of that money back into the market. Client A decides to buy mutual funds and ETFs with his $500,000. Client B, at your recommendation, decides to invest in a handful of equity accounts within a variable annuity.

Looking Ahead

Fast forward three years and the market has fully recovered, thereby turning both $500,000 investments into $1 million. For simplicity purposes, I have ignored the capital gains on the mutual funds and the likely higher fees on the variable annuity. For Client A, you are once again faced with the dilemma of how to reduce equity exposure without incurring significant taxes.

With Client B, though, you don't have that dilemma. All you need to do is reallocate some of the money from the equity sub-accounts to one or more of the many non-equity sub-accounts in the variable annuity. Because the transfers were all done within the annuity, no taxes are incurred. For Client B, the variable annuity becomes the means for dialing her equity exposure up and down as conditions dictate.

LIMRA estimated that variable annuity sales, excluding group plans (i.e., 403(b)s), were about $80 billion in 2019 — a number that hasn't changed much in four years and is 50% below what was sold in 2013. According to LIMRA's research, about 50% of these sales had a living benefit attached.

Somewhere along the way, we convinced advisors that a variable annuity had to have a living benefit to be a valuable tool. Advisors and variable annuity companies almost solely are focusing on which product will provide the most guaranteed income. Of course, guaranteed income is an important need, but it is not the only need a flexible variable annuity structure can meet. Instead, variable annuities can be effective planning tools for clients who are comfortable taking on market risk, want the flexibility to reallocate their portfolio without incurring capital gains within a tax-deferred structure, and can provide a death benefit to their heirs. Sometimes it's important to think accumulation, not income — it worked for the first 20 years variable annuities were in existence.

Last I checked, clients still want to see their portfolios grow, they don't want to pay taxes, and they want to be able to dial down their risk if they get nervous about the market. For the right clients, a variable annuity provides accumulation and allows for rebalancing within the annuity without incurring capital gains. Let's go back to the basics of variable annuities to potentially help your clients, especially in this market environment.

Scott Stolz, CFP, RICP, is president of Raymond James Insurance Group.

— More by Scott Stolz: